Today’s lesson from C.A.S.H is on the risk of hobby loss on your rental property. That’s right, your rental house follows a similar set of rules when it comes to acting as a rational investment.
See, the guiding principal behind every investment is the concept of making money. Congress enshrined this ideal in IRC 183. And taxpayers and the IRS have been fighting ever since. The basic concept is that no one invests to lose money and real investors would not continue to pour money into an investment that can never recover. Logical.
This same problem comes up with rentals. John Caton and I were discussing this issue yesterday. We were waxing nostalgic about some of the things we had seen over the years. His story beats mine on this subject so I will use his. Names, places and amounts have been changed to protect the innocent.
Hal, an executive with a decent sized construction company, was married with 2 children. Hal came in for a tax interview. He said Wilma, his wife, would arrive in about 15 minutes. While they waited, Hal asked John what the requirements for claiming a dependent were because he was thinking he should add two more because he was providing over half of their support.
John explained that there had to be some relationship between the taxpayer, in this case, Hal and Wilma, and the person claimed as a dependent. Plus, they had to provide over half of the support. John pointed out that caring for their aged parents would qualify but if they had siblings then Hal would want to get a letter from them saying they all agreed Hal and Wilma provided the majority of support.
Hal was silent for a moment. Would that include providing housing? Hal inquired. John, being a curious accountant – how he survived to middle age being curious is still a mystery – asked him to explain. What if he rented a house for them? Possible but it would depend. (the profession’s get-out-of-jail-free card)
About that time, Wilma came in and John said he would get back to Hal about his thoughts. Hal said to forget it.
On Hal’s and Wilma’s 1040 was a rental property. Hal bought it for an investment 5 years earlier. The property generated about $9,000 in rental income and generated total expenses of about $22,000. This had gone on for all 5 years but year 1 had a loss of almost $40,000.
Fast forward about 6 months. Wilma comes in for an appointment. The IRS wrote wanting an explanation of the losses for years 1 and 2. John was quite curious as Hal typically handled these types of things. John assumed that Hal was off on some job site.
No, that wasn’t it. Wilma starts crying in his office. John thinks the worse, Hal passed away.
By the way, death is not the worse apparently. Not even close in some instances.
Wilma goes on to explain. The two dependents Hal inquired about? His girlfriend and their 4 year old child. Yes, it seems good old Hal bought the rental when he found out she was pregnant.
The rental, she told him, wasn’t one. Hal confessed to her he actually made the income number up. The expenses? Well, the mortgage interest and the property taxes were real but the rest were all expenses paid to support the girlfriend and their child. Furniture, clothes, food, you name it, he claimed it as a rental expense.
No income, no real expense but years of losses. a husband with a love child and an IRS audit waiting in the wings. Wilma was, to no ones surprise, not very happy. But she said there was an upside.
After she kicked Hal to the curb, he apparently went to the girlfriend to tell her he was ready to commit to her. When he arrived, the girlfriend was entertaining a guest for dinner. Her new boyfriend.
Like I said, death would have been the easy thing for Hal.
Yes, I know, not really a story about rental losses. True but frankly it had such an interesting message that I couldn’t pass up writing about it. But the story did touch on the hobby loss implications.
Typically with rentals, losses are considered passive and have limitations as to their deductibility. The preparer felt that Hal was a “real estate professional” and, instead of limiting the losses, took the full amount Hal and Wilma were entitled to. This, by the way, was the reason for the initial IRS inquiry – to determine if they qualified. John felt he could win that argument – everything else being equal.
John knew that the next argument was the risk of hobby loss. John made Hal go out and do market research each year on fair rental amounts. This is known as the business plan defense. The $9,000 was on the low end of the range but would likely have passed – except for the minor little problem of it being fictitious. Interestingly, the made-up rents less the mortgage interest, property tax and depreciation were almost at breakeven.
Hal wanted to be a hog. The IRS slaughterhouse is full of ’em.
The preparer was totally blindsided by the, shall we say, aggressive approach to expenses. Had Hal been fully honest, no one would have allowed baby clothes to be deducted. Other than the possible tax fraud, it sure looked like an activity engaged in for profit and therefore the losses – the real ones – should have been allowed.
The C.A.S.H. moral of the story? There are so many in this one but I think the key takeaway is pigs get fat and hogs get slaughtered. Don’t get branded a hog.
Oh, and multiple years of rental losses don’t necessarily mean that the activity is a hobby. Make sure rents are reasonable for your area, that amenities are fair and can be priced into the rent or are expected in the marketplace. And for crying out loud, don’t try to fool your spouse by sticking the second family in the rental house!
My thanks to John for the amusing story. As always, if you have any questions or would like more information on hobby losses or real estate, feel free to contact me.
Have a great day.
Accounting Clarity 