Converting Home to Rental to Get Tax Loss Deduction

If you move out of a house and rent it to a friend for less than fair market value rent, can you then take a tax loss on the subsequent sale of the house?

If the home is not converted to a rental property, the loss is disallowed as a personal tax loss. If the home is converted to a rental property, the tax loss is allowable.

This is a very common scenario. It is one that taxpayers can proactively change the facts and trigger substantial tax loss deductions. This is where a little advanced tax planning can result in significant tax savings.

The appeals court recently considered this question in Langston v. Commissioner, No. 19-9002 (10th Cir. 2020). The IRS and the courts will scrutinize any perceived tax planning in this area. The Langston case is evidence of this. The appeals court went out of its way to find arguments to deny the taxpayers tax loss deduction.

Facts & Procedural History

The taxpayers purchased a house in 1997. They moved out of the house in 2005 to start renovations on the house.

They lived in an apartment for three years before they purchased another home (in 2008). The renovations on their prior home continued for two more years (i.e., through 2010).

In 2011, the insurance agent advised the taxpayers that the insurance for their prior home would be cancelled if the house was not occupied. The taxpayers rented the property to a colleague for limited use:

Although the fair-market rent was approximately $2,500 to $2,800 per month, the Langstons rented the Property to one of Mr. Langston’s former fraternity brothers for the prorated amount of $500 a month, because he only used the home five days a month.

The taxpayers listed the property for sale a year later. The property was sold for a loss in 2013. The taxpayer’s reported the tax loss on their tax return for 2013.

The IRS audited the tax return and disallowed the tax loss. Tax litigation ensued.

The question was whether the year of limited rental activity is sufficient to convert the loss from a non-deductible personal loss to a deductible business or investment loss.

About Tax Loss Deductions

Taxpayers are generally entitled to deduct tax losses. This deduction is found in Sec. 165.

Section 165 allows a tax deduction for any loss incurred in any transaction entered into for profit.

The regulations clarify this broad language in Sec. 165. For example, the regulations say that a loss “sustained on the sale of residential property purchased or constructed by the taxpayer for use as his personal residence and so used by him up to the time of sale is not deductible under section 165(a).”

The regulations go on to say that a tax loss deduction is allowable if the taxpayer “rent[s] or otherwise appropriate[s]” the property “to income-producing purposes” and uses it “for such purposes up to the time of its sale.”

Income-Producing Purposes

To be able to deduct a loss on a rental property, one has to show that the property was held for income-producing purposes.

The court cites this rule from Grant v. Comm’r, 84 T.C. 809: “Whether an individual holds property for the production of income is a question of fact, and depends on the purpose or intention of the individual, as gleaned from all of the facts and circumstances of the particular case.” It goes on to cite the following factors from Grant:

1. How long the taxpayer used the property as a personal residence,
2. Whether the individual abandoned all personal use of the property,
3. Whether the character of the property was recreational,
4. Whether the property was offered for rent, and
5. Whether the property was offered for sale.

The court in Grant gets these factors from the Meredith v. Commissioner, 65 T.C. 34 (1975) case. The Meredith case is instructive. Let’s stop to consider that case.

The property in question in the Meredith case was a vacation beach home. The taxpayer stopped visiting the house and asserted that it was held for rental. The court concluded that the taxpayer’s “rental efforts were spasmodic and halfhearted during the years in issue.” It concluded that the taxpayer “did not make a bona fide attempt to rent the property during these years.”

The facts in the present case are substantially different than those in Meredith. For one, the taxpayers actually rented their house in the present case. They did so for a whole year. Their was also no evidence that the taxpayers in the present case continued to use the house, as the taxpayer did in Meredith. This would seem to negate all of the factors cited in Grant.

Did the appeals court care? No. It said “[w]e have carefully reviewed those findings and conclude they are supported by the evidence.” The appeals court does not explain what evidence it refers to as none of the evidence described in the appeals court’s opinion would seem to support the holding.

Evidence of FMV of Real Estate

The appeals court raised a new issue and concluded that the taxpayers were not entitled to the tax loss deduction based on the new issue.

We also affirm on an additional independent ground. The Langstons presented no evidence of the fair market value of the Property at the time of the conversion in 2005, and without this evidence there is no way to calculate the loss. See § 1.165-9(b)(2)(i)-(ii).

The Langstons contend that we cannot consider the issue because the Tax Court did not identify it as a basis for its decision. That is incorrect. We have consistently held that “we may affirm on any basis supported by the record, even if it requires ruling on argument not reached by the district court or even presented to us on appeal.” Richison v. Ernest Grp., Inc., 634 F.3d 1123, 1130 (10th Cir. 2011).

How frustrating is that for the taxpayers?

The appeals court likely raised this new issue fearing that it’s holding on the primary issue would be overturned on appeal. By raising this new issue instead of remanding the case to the tax court to consider this new issue, the appeals court has stacked the deck against the taxpayers for their appeal of the appeals courts opinion.

This is troubling when you consider the new issue the appeals court raised. Looking at the substance of the appeals court’s new issue, was there really “no way to calculate the loss?”

Could the appeals court not use this evidence to estimate the fair market value?

• The tax return was in evidence apparently. The tax return includes a form that shows the calculation. This calculation shows the sales price. The sales price is a good indicator of the fair market value. The house sold less than a year later. Is that sales price not close enough in time to use as the fair market value?
• It appears that the tax attorney who prepared the return testified in the case. Is the tax attorney’s testimony not sufficient?
• The appeals court opinion says there was an appraisal of the fair market value from a few years earlier. Is the appraisal not sufficient?
• What about the cost basis plus the value of the improvements, which are numbers recited in the appeals court’s opinion? Can the appeals court not consider this combined amount?

Could the court not estimate the value based on the totality of this evidence? If the appeals court could not estimate the value using this evidence or felt that this was a fact finding function that should be handled by the trial court, should it have remanded the case to the lower court to do so?

If remand to the trial court is not an option, one is left wondering if the appeals court can raise a new issue on appeal, can the taxpayers submit additional evidence on appeal after the appeals court announces the new issue? Why can’t the taxpayers submit an appraisal report for the court to review? It is not difficult to hire an independent appraiser to prepare an appraisal report. That would be easy to do. It would be easy for the appeals court to review.

If not, could they ask the appeals court to take judicial notice of known facts for the new issue raised on appeal or could the appeals court not do so on its own? For example, could the taxpayers ask the appeals court to take judicial notice of the property tax assessor’s value? This information is publicly available and easy to locate.

Importantly, this new issue would not have been a bar to the tax loss deduction if the IRS had raised at the trial court level. This new issue may have reduced the amount of the tax loss deduction, but it would not have eliminated the tax loss deduction. This is the case as the taxpayers could have presented evidence of the value. This evidence would have established that there is some value, as the property clearly had some value.

This is the type of evidence the taxpayers could have presented at the trial court level. Should they be barred from doing the same just because the appeals court raises the issue for the first time on appeal and because the appeals court does not remand the case?