IRC 280 Improper Below Market Rent Handling

[ACCLIGHT]

The following is an unfortunate example of how a simple code miss over time can create a bit of a challenge. I am having difficulty determining a path of resolution and would appreciate constructive input.

Facts and Circumstances:

An LLC rents residential and commercial properties. For years the LLC has for reasons of generosity rented a portion of its residential properties at well below fair market rents. Although these properties remained generally profitable neither the partners nor multiple preparers recognized that under IRC §280A(d)(2)(C) these residential rentals had to be treated as personal use. As such none of the deductions which the LLC was accustomed to and claimed were allowable (except for interest, taxes (10K) and casualty losses as passthroughs).

The LLC partners desire to correct the returns and comply fully with code. This appears to mean recognizing the income personally and removing depreciation and expenses except for those passthroughs allowable for itemization. Many of the properties in question have been sold and the gain or loss recognized would be potentially very different based on the depreciation and capitalization changes needed.

Questions:

• Should the partnership returns be amended for all years open under statute or should a 3115 with all adjustments be filed in the current year? This is not just a question of convenience but that moving from depreciable property to non-depreciable property is a change in accounting method. While the returns can be easily amended I am not sure that the changes to depreciation via amendment would be allowable.
  
  
• Since the LLC owns the properties what happens to the capital expenses incurred during the period the IRS is considering personal use (such as HVAC, roof, etc.) Are those carried as non-depreciable assets or simply washed off?
  
  
• Finally, since this will result not in a refund but amount owed how far back should this be chased? Open years? All years affected?
  
  

Please bear in mind I have purposefully not included a discussion of fair market rent and related code. That has been previously evaluated and my hope would be that the thread could focus largely on the issues created by treating properties as fair rentals vs personal use. Thanks in advance for your input.

[qbteachmt]

"remained generally profitable"

So, it's not an issue of personal use or renting to family members? Are the properties in tip top condition? We have some rentals around here that should never go for market rate.

"Presumption of profit. If your rental income is more than your rental expenses for at least 3 years out of a period of 5 consecutive years, you are presumed to be renting your property to make a profit."

[BobKamman]

It's only since 2017 that the other expenses have not been allowed as a miscellaneous deduction on Schedule A.  So it might not have made much difference, until then. 

Sounds like a family partnership where Mom and Dad got a discount on rent.  But was what they were paying, really below FMV taking into account that they were good tenants, unlikely to move out, while keeping an eye on the rest of the property?  

If the returns are audited, concede the issue.  That might mean going back three years.  Otherwise, there is no law requiring amended returns, absent fraud.  Let sleeping dogs lie.  Leave the can of worms unopened.  Or is one of the kids now running for office and wants to disclose his returns, to an opponent who is a CPA?  

[Terry53029]

I realize you said you did not want to discuss fair rentals, but if " generally profitable" to strangers at a arms length transaction, and no personal use I would consider that fair market value. I would definitely not worry about properties that have been sold. I also would not amend any of them. In my opinion I would not file a 3115, but that would be the correct way. I have had several clients with rental property that are profitable, but have not raised rents as they don't want the hassle of new clients, and over the years those property's are falling below other property's in the area, but as I said if profitable, then that is market value. Just my opinion.      

[BobKamman]

What are your options if you learn of a mistake on your income tax return?

If you filed an income tax return and believed it to be true and correct when originally filed, you have no obligation to file an amended income tax return. There is no statute or caselaw that requires you to notify the IRS of your error. Indeed, the concept of an amended income tax return is not recognized in the Tax Code—taxpayers have no obligation to file them, and the IRS has no obligation to accept them. The Supreme Court, in Badaracco v. Commissioner, 464 U.S. 386 (1984), noted that amended returns are "a creature of administrative origin and grace." Indeed, even if you did not believe your return to be true and correct when you originally filed it, you still have no duty to file an amended income tax return, and filing one will not help you undo criminal exposure from your previously filed return. See Badaracco, 464 U.S. at 397.

Treasury Regulation 1.451-1(a), at first blush, appears to provide an obligation to file an amended return:

If a taxpayer ascertains that an item should have been included in gross income in a prior taxable year, he should, if within the period of limitation, file an amended return and pay any additional tax due.

Amended returns are also mentioned in Treasury Regulation §§ 301.6211–1(a), 301.6402–3(a), 1.461–1(a)(3)(i). Section 6213(g)(1) of the Tax Code itself also mentions an amended return. The Supreme Court, however, noted in Badaracco that “none of these provisions, however, requires the filing of such a return.” Accordingly, you have no obligation to file an amended return despite any error that you may find in your original income tax return.

https://www.keimtaxlaw.com/do-you-have-a-legal-obligation-to-file-an-amended-income-tax-return 

[ACCLIGHT]

Thanks Bob this is really good info on the right to let sleeping dogs lie. In this case the returns need to be amended for other items as well which makes it more difficult for an honest taxpayer who feels there is an unaddressed or incorrect issue. I think your comment is a really broadly helpful one and hope many others will find it as a resource. Thanks again for your effort. 

[ACCLIGHT]

Thanks for your wise input Bob. Normally your guess would likely be the case. Here the tenants were third parties knowingly provided below market rents to assist them in various circumstances. The LLC's intention was to be profitable while in certain instances doing good for individuals within the community. A good thing but as with imputed interest the IRS sometimes sees things differently or perhaps closed a legitimate loophole to broadly. You points are helpful though. I think a case can be made for the value of quality tenants that care for a property and the fact they were unrelated might be a help in the event of scrutiny.

[ACCLIGHT]

Thanks Terry. I appreciate your careful read. I did say I wanted to steer clear of the fair rent discussion because it is easy to get into the weeds but it is an important topic. If the "generally profitable" definition of IRC §183 was the override I could drive a truck down that road. Unfortunately my understanding is that for residential §280A is the factor. I comment a bit more on in  response to another commenter. 
What was really helpful to me is your concurrence on 3115 as well as relaying history with your other clients. I think this is likely a very common situation. Some landlords are kind and soft hearted or just behind the curve. The may like or feel sorry for a tenant or simply not bother to know an keep up with the market. Unfortunately here is a regulation the Landlord is likely entirely unaware of.

I can understand what is likely the legitimate intention of the IRS but unfortunately the code does not really have the clarity it should. I very much like your take on it and give you my vote for the next IRS commissioner.  

[ACCLIGHT]

Thanks for your effort to respond qbteachmp. The presumption of profit you mention I believe refers to  IRC §183. I also thought that held the answer. Unfortunately this is a residential unit so it is subject to subject to IRC §280A. While this is often thought of in reference to family members the code specifically applies "to any individual  (other than an employee with respect to whose use section 119 applies) to whom the property is rented for a rental under the facts and circumstances, is fair rental."

While fair market rents are not explicitly defined Publication 527 provides:

"A fair rental price for your property generally is the amount of rent that a person who is not related to you would be willing to pay. The rent you charge is not a fair rental price if it is substantially less than the rents charged for other properties that are similar to your property in your area."

Regrettably in this case the properties were well maintained and despite meeting the presumption of profit of 183 would seem not to meet the fair rental 2(C) Provision of 280. For anyone interested in the painful history and how a below fair market rental becomes classified as personal use here is a valuable resource: ALR Section 280A Discussion and Overview 

Really good thoughts and suggestions. Thanks

[Terry53029]

There was one tax court case where I believe "fair market rent" was at least 80% of similar properties in the area. I'm sure @BobKamman  knows of it, and maybe could provide a link. 

[BobKamman]

If you go to the Tax Court website, it will give you the first 100 cases where "fair rental value" appears in an opinion.  It's quite possible that in one case, based on all the facts and circumstances, the rent was allowed if it came within 80% of comps.  But the Tax Court is not in the business of issuing bright-line rules that can be applied to every case.  

[qbteachmt]

"Unfortunately this is a residential unit"

By an LLC, so that offers some perspective to the operation.

"The LLC's intention was to be profitable while in certain instances doing good for individuals within the community."

So, that's a niche and intent. For instance, my town has the most Not For Profit organizations per capita, right behind Berzerkley, CA. That means we have, as an example, housing programs on offer to those needing a hand up, not a hand out. The landlords have put their properties in the availability pool and there are eligibility terms (similar to section 8), such as International Rescue Committee housing. I promise you these units are not charged rent at FMV to the general market, which includes the University here.

"if it is substantially less than the rents charged for other properties that are similar to your property in your area"

In your area, of that type, and for that similar purpose. Also taking into consideration what performance measures the tenant has to meet to be able to rent that property, such as yard work and general responsibilities and maintenance, similar to an on site manager. And perhaps meeting Parole Officer requirements, clean drug tests, proof of required attendance to rehab or retraining classes or certifications, children not being truant, applying for and keeping jobs. One of my largest clients is a pre-release center. There can be out-living placements still under the terms of the pre-release.

A clear intent to sidestep a FMV requirement is not the same as a reasonable justification for setting an amount to charge for rent in specific circumstances. Doing a FMV rental study and comparison won't apply to dissimilar property.

It's like "innocent until proven guilty." Your client isn't the party that has the onus to declare if there is a problem, consider it a problem, and demand an adjustment to resolve a problem. Your client has an operational intent that still may meet due diligent.

I side with Bob in this example: this is a hot potato that doesn't need to be handled, most likely, even if there are clear amendments needed elsewhere.

(CAGMC = come and get me, coppers)

[ACCLIGHT]

Thanks for your thoughtful answer and unique perspective. That is very helpful. Plus if you and Bob are on the same page it is almost a poor mans private letter ruling (  :  Thanks guys.

[BobKamman]

Let's try to avoid the childish slams at Berkeley.  I don't see it on this list, nor do I see Missoula in second place.  

Where Are All the Locally Focused Nonprofits?

Metro Area	Nonprofits	Nonprofits Per 10k Population
Barnstable Town, MA	517	24.2
Pittsfield, MA	286	22.6
Santa Fe, NM	285	19.0
Missoula, MT	219	18.4
Ithaca, NY	187	18.2
Springfield, IL	358	17.2
Trenton, NJ	634	17.1
Bismarck, ND	222	16.7
Napa, CA	231	16.6
Madison, WI	1,094	16.6
Burlington-South Burlington, VT	366	16.6
Boulder, CO	538	16.5
Duluth, MN-WI	447	16.0
Great Falls, MT	130	15.9
Fairbanks, AK	157	15.9
Glens Falls, NY	198	15.8

[qbteachmt]

Childish? Where do you think that comes from?

https://www.dailycal.org/archives/investigating-the-origins-of-berserkeley/article_e2c93f5e-77cb-558...

Just like we have Boz Angeles.

What does "locally focused" have to do with anything? I never understood why you sometimes focus on some random detail that isn't even important to the topic.

[BobKamman]

The very tired joke, from the gossip columnist who died in 1997, has become a dog whistle for the people who dislike the non-demagogue candidate in the current presidential race. Because, that’s her home town. And it’s what the guy with no college degree, but even more wives than the current loser nominee, called it before she was born.

The significance of “locally focused” means that it excludes such items as scholarship funds earmarked for nonbinary redheads from Montana. Lots of scholarship funds may claim a Berkeley address. What’s your source?

[qbteachmt]

How did you go from "local focus" to "scholarships?"

Here's one example for Missoula area nonprofits::

https://www.causeiq.com/directory/missoula-mt-metro/

"There are 1,993 organizations in the greater Missoula metro area"

You want per 10k? Even with the stupid move-ins from Yellowstone TV show, Missoula still is about 77k. You can do that math.

[BobKamman]

I was just wondering about your source for Berkeley being first and Missoula second.  

Must have been someone at the beautician.