Tax Court Rules on Vacation Home Losses

In these uncertain times, many of your clients who rent out their vacation homes may end up reporting a loss for the year and getting the tax deduction. However, Lucero, TC Memo 2020-136, 9/29/20, shows that due to the “passive activity loss” (PAL) rules, it’s difficult to deduct a loss even if your personal use remains within the tax law limits.

Oct 21st 2020
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Generally, if your client rents out a vacation home to tenants while they’re not using it personally, they can deduct expenses to offset taxable income from the rental. This includes expenses such as mortgage interest, property taxes, repairs, utilities, insurance, etc. (Depending on the situation, mortgage interest and property may otherwise be wholly or partially deductible on personal return for a qualified residence). 

In fact, you may even be able to deduct a loss for the year if expenses exceed income. To qualify, your personal use of the vacation home can’t exceed the greater of

(a) 14 days or

(b) 10 percent of the time the home is rented out

But there’s yet another tax obstacle to overcome. Under the PAL rules, you can only use losses from a rental activity to offset losses from other passive activities, with certain exceptions. Notably, a loss from short-term rentals of a vacation home may be allowed if the taxpayer “materially participates” in the rental activity.

Material participation requires involvement in the activity on a “regular, continuous, and substantial” basis. The IRS regulations have created several tests for establishing material participation. For example, a taxpayer satisfies one test if he or she spends 500 hours a year on the activity.

Facts: In the new case, the taxpayer owned a short-term-rental property at Sea Ranch in California, several hours from his home in Sacramento. He rented the property to tenants for 146 nonconsecutive days in 2014 and 152 nonconsecutive days in 2015.

The taxpayer paid a property management company to manage the property’s day-to-day rental operations, including advertising to prospective tenants, collecting deposit fees and rent, maintaining and cleaning the property between stays, landscaping, assisting him in hiring repair subcontractors and responding to tenant comments and complaints. He retained control over certain administrative decisions such as setting rental rates and approving expenses over $100 (unless there was an emergency).

To save money, the taxpayer performed some personal upkeep on the Sea Ranch property, driving to it approximately six to nine times each year to landscape, clean and take inventory and make and/or oversee any necessary repairs. In 2015, his wife accompanied him on these trips and helped with the work. They stayed at the Sea Ranch property with family for approximately one week during Christmas each year.

The taxpayer claimed losses for the vacation home rentals for the 2014 and 2015 tax years. However, he did not keep any contemporaneous records or documentation indicating the number of hours spent on activities at the Sea Ranch property for the years in issue. Instead, he created a log while being investigated by the IRS, attempting to reconstruct his activities.

In that log, the taxpayer estimated that he spent a total of 267 hours on activities for the Sea Ranch property in 2014 and that the couple spent a total of 273 hours on activities in 2015. The activities included paying bills, buying supplies, performing maintenance and repairs, traveling between Sacramento and Sea Ranch, coordinating with the management company and preparing their tax returns.

Tax outcome: The Tax Court was not impressed. It remained skeptical of the records and discounted certain activities such as time driving to the rental property. In the view of the Court, the taxpayer’s estimates were exaggerated. In the end, the losses were denied.

Moral of the story: It is important to keep detailed and accurate records to prove material participation. Advise your clients about the requirements.

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