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New Tax Court Case Sheds Light on Capital Gains and Losses

If your clients own vacation homes they rent out, there are a number of benefits they can reap in terms of taxes. But as a couple recently found out, the Tax Court is quite strict on the requirements that must be met before anyone can benefit.

Aug 27th 2020
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The tax law provides a number of tax benefits for investors in real estate who hold out their property to tenants for rent. For instance, you may be able to claim a loss that can offset highly-taxed ordinary income. However, as shown by a new Second Circuit case involving a renovated mansion, Keefe, CA-2, No. No. 18-2357-ag, 7/17/20, you must meet certain requirements to realize this tax benefit.

Generally, losses from sales of real estate are treated as capital gains or losses. Capital gains and losses are first used to offset each other. Then, if there is an excess loss, it’s used to offset up to $3,000 of ordinary income. Any remainder is carried over to the next year.

However, losses that are not treated as capital losses are fully deductible as ordinary income loses. They can offset ordinary income—for example, wages from a job—that is currently taxed as high as 37 percent.

The couple in the new case purchased a historic mansion in Newport, Rhode Islands for $1.35 million . Over time, they spent million of dollars renovating the place, as well as substantial time and effort. But they never lived in the house; nor did anyone else.

In 2006, the couple met with a real estate agent to discuss renting the home. They expected the home to produce monthly rental income of $75,000 during the summer months and $10,000 a month during the rest of the year. The couple hoped that the renovations would be completed in 2007 and that the place could then be rented out.

The real estate agent began speaking to clients about renting the house in 2007. But she did not advertise any listing online because she didn’t believe she could market the house while the renovations were ongoing. After further delays, the couple hoped the house would be ready to rent during the summer of 2008. The agent continued to inspect the house and to discuss prospective rentals with her clients throughout the rest of 2007 and into 2008.

Only one client expressed an interest in renting, but he did not enter into any rental agreement or pay a security deposit. After the restoration was finally completed in May 2008, the house was no longer held out for rent. Ultimately, it was never rented out. The couple eventually sold the mansion at a huge loss.

Key point: Property held for the production of income, but not used in a trade or business of the taxpayer, is treated as a capital asset. Rental real estate is considered a “trade or business” if the taxpayer-lessor engages in regular and continuous activity in relation to renting the property.

The taxpayers in this case didn’t conduct any rental activities other than consulting with a real estate agent.  No rental agreements were ever signed. Accordingly, the Second Circuit Court determined that this was not a continuous rental activity. The loss must be treated as a capital loss.

Make sure your clients don’t make the same mistake. Have them engage in rental real estate activities that will preserve a fully deductible ordinary income loss.  

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