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Rental home deduction disaster

October 18, 2011

When a school assistant principal took a new job in Minnesota, she held on to her house outside Kansas City and tried to lease it. Her tale as told in Tax Court yesterday provides lots of lessons in deducting rental losses.

Because she had adjusted gross income under $150,000' she didn't have to pass the difficult test of being a "real estate professional" to deduct her losses. She had to meet the much lower "active participation" test. The judge said she did:

The active participation standard can be satisfied without regular, continuous, and substantial involvement in an activity; the standard is satisfied if the taxpayer participates in a significant and bona fide sense in making management decisions (such as approving new tenants, deciding on rental terms, approving capital expenditures) or arranging for others to provide services such as repairs. Madler v. Commissioner, T.C. Memo. 1998-112.

In the instant case, it is clear that petitioner owns the Kansas City house and that she is the one who is not only responsible for making all management decisions but who in fact makes such decisions. We therefore find that petitioner satisfied the active participation standard in 2006 and 2007 and is therefore entitled to offset her nonpassive income for 2006 and 2007 by her substantiated rental losses, subject to the phaseout limitation (potentially applicable only in 2007).

The judge stressed the substantiation requirement for a reason. The court found that the taxpayer kept less than meticulous records, using excuses that she might have heard from wayward children in her school:

In the instant case, the documentary evidence regarding the disputed deductions is relatively scant. At trial, petitioner testified that she kept her tax records in the basement of her home in Minnesota and that the basement was flooded on three separate occasions, once when a sump pump failed, once when her hot water tank failed, and once after "a big storm", which "soaked" certain of her records, prompting her to throw them out. However, it remains unclear why petitioner could not have reconstructed at least some of her records by contacting third-party payees, such as insurance and utility companies. Indeed, at trial, petitioner did not testify that she made serious attempts to do so.

The judge estimated some of the unsubstantiated deductions under the "Cohan Rule'" but the travel expenses for trips to the home failed the strict travel substantiation rules and were fully disallowed. The court allowed about $13,000 of the $25,000 deductions claimed and imposed a 20% penalty on the taxes owed.

The moral? Keep good records, and watch out for high water.

Cite: Bonds, T.C Summ. Op. 2011-122

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