Tax & AccountingOctober 07, 2020

Real Estate Professional’s Short-Term Rental Property Generated Passive Losses


Real Estate Professional’s Short-Term Rental Property Generated Passive Losses

Real estate professionals who own short-term rental properties that are managed by a third party may find it more difficult to escape the grasp of the passive loss rules. A recent decision of the Ninth Circuit Court of Appeals (Greg A. Eger, Et. al., 2020-2 USTC ¶50,166) contains bad news for owners who pay others to manage their short-term rentals of vacation homes, time-shares and AIRbnb properties.

Real Estate Professionals Can Usually Deduct Passive Rental Losses

Rental activities are generally passive. Consequently, most losses from a rental activity are deductible only against income from the rental activity or some other activity with net passive income.

However, since the taxpayers in this case qualified as real estate professionals, they could deduct their rental activity losses against other income. The question before the court was whether their rental properties that were managed by third parties could be grouped with their other rental properties into a single rental activity.

Taxpayers Grouped Properties Managed by Third Parties with Other Properties

The dispute in the Ninth Circuit involved three rental (resort) properties that the taxpayers owned in Mexico, Colorado, and Hawaii. All three properties were managed by third parties.

The taxpayers actively operated 30 additional rental properties. They treated all 33 properties as a single rental activity that generated losses.

Ultimate Renters, Not Management Companies, Were Taxpayers’ Customers

The IRS argued that the three resort properties were not rental properties and, therefore, they could not be grouped with the taxpayers’ larger rental activity. The Service relied on a regulation that excludes property from a rental activity if the “average period of customer use for such property is seven days or less” (Reg. §1.469-1T(e)(3)(ii)(A)).

A period of customer use is “each period during which a customer has a continuous or recurring right to the use” the property (Reg. §1.469-1(e)(3)(iii)(D)). However, the regulations do not define “customer.”

So Who is the Rental Customer?

According to the IRS, the people who rented the taxpayers’ properties were the customers. Since their rental periods averaged seven days or less, the rental of these three properties was not a rental activity.

The taxpayers, however, contended that the management companies were the customers, and their use of the property extended over the entire period of their management contracts. Since those periods far exceeded seven days, the three properties were properly included in the taxpayer’s rental activity grouping.

The Ninth Circuit agreed with the IRS, and interpreted “customer” to mean the guest who actually used the rented property. The management companies, on the other hand, were simply service providers that acted as the “representatives” of the taxpayers.

District Court Had Relied on “Continuous Use” Requirement

The district court (2019-2 USTC 50,248) had also ruled against the taxpayers, but its reasoning was different. It treated the management companies as the customers but found that they did not have the required “continuous right” to use the resort properties for periods in excess of seven days.

The management contracts gave the taxpayers the superseding right to use the properties as long as they provided advance notice. Regardless of whether those rights were actually exercised, their mere existence meant the management companies did not have the continuous right to use the properties.

Importantly, the district court distinguished two earlier tax court decisions that treated management companies as the customer. In those cases, the taxpayers did not reserve the right to use the rented property–heavy machinery in one case (Kenneth M. HairstonDec. 54,162, 8 TCM 905, T.C. Memo 2000-386) and a yacht in the other (White, T.C. Summ. Opp. 2004-139).

Ninth Circuit Stakes Out New Ground on Rental Management Contracts

The Ninth Circuit did not discuss the District Court’s reasoning or the two Tax Court decisions that treated a management company as the customer. Nevertheless, it appears the Ninth Circuit will not follow any of those decisions in similar circumstances even if a taxpayer does not reserve the right to use the rented property.

It is worth noting that the taxpayers in this case, as well as the two tax court cases, entered into management agreements that split the rental income in a specified amount. The Ninth Circuit might have reached a different conclusion if the taxpayers received fixed payments without regard to whether or not the management company secured renters. Such arrangements would be similar to a traditional lease that simply includes the right but not the requirement to sublease.

By Ray G. Suelzer, J.D., LL.M. 

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