Rental Sanity Check

[Skylane]

New client owns 3 family for 20+ years. Rented 2 apts and occupied one. .  One of the tenants moved out in 2019. Returns  through 2022 returns show 2/3 rented to others. Not good.

Owner is not intending to rent second apt but will use for personally,  storage, place for family and grandchildren to visit etc. (his wife doesn't let him smoke or bring his girl friend  in the house, so it's a good hiding place)

I'm going to suspend deprecation of 2nd apt. and show property as 2/3 owner occupied.

Just want to verify that if he decides to sell the property after 2 years, 2/3 of the CG on the adjusted building would be subj. to IRC 121.

[TaxGuyBill]

You want a sanity check in March?  I don't know if any of us would pass that.  😂

From the way you described it, it seems questionable if this separate "dwelling unit" is part of their Principal Residence or not.  I would say no.

*IF* it does qualify as part of their Principal Residence, the time from 2009 until it was converted to personal use would normally be "Nonqualified Use".  But I would need to think about if that would apply here or not.  But as I said before, my first inclination is that this separate "dwelling unit" would not qualify.

[BobKamman]

He could sell it tomorrow and exclude the gain on 2/3 of the property.  Might be a good idea to file amended returns for 2020-21.  Even if they don't sell the place.  

[itonewbie]

This sounds very much like a USTC case I read about a while ago.  I'll see if I can pull that up and give you the citation.

Essentially, it's about a guy in NY who owned two apartments in a condo.  If I remember, for a time, he allowed his son along with his wife (and perhaps their young kids) to stay in the second apartment as their home.  They subsequently moved out and he never got around letting that vacant unit out.

Eventually, both units were sold (or may be one) and he argued that he had been using that second apartment as part of his home, that he had plans to knock down some walls to connect the units although it was never done, etc.

The court didn't feel that his position has legs to stand on and denied him the tax benefits because it considered those to be separate dwelling units.  I can't recall all the details but it's something along that line.

[Edit: Turns out to be a district court case]

[rbynaker]

Has any work been done to tear down walls and make this one unit?  I've had clients who have done that.  Once they started having kids, rather than move to a new house with more bedrooms, they just expanded their dwelling unit to include the rest of the duplex.  Obviously that depends on the physical situation.

I'm not sure if it's relevant but has anything been filed with the city/county to merge the dwelling units?  Around here Zoning would have to get involved at some point to legally "merge" two residences.  YMMV.

As Bill mentioned, you're not going to have a full exclusion in any case.  You'll have gain to the extent of depreciation AND prorated gain based on the Nonqualified use from 2009-2019.  I haven't had to do that math in a while so I'd have to look it up.

Were the rental losses allowed or limited?  I can't imagine you'd go from full 2/3 rental to only collecting half the rent but still reporting all of the expenses and have net income.  If there's no change to the bottom line on the tax returns from 2019-2021 I might be inclined to just refigure the carryovers and keep that documentation on file.  Then use the correct information moving forward.  You could include a preparer note with the 2022 return but I don't know that you'd need to if the tax did not change any.  If it does change taxable income I would likely disengage if they don't choose to amend.  Life's too short.

Rick

[itonewbie]

Here's a link to Cohen vs U.S., 999 F.Supp.2d 650 (2014):

https://www.leagle.com/decision/inadvfdco141216000053

[Skylane]

Thanks all for your replies!  Good food for thought and will certainly go in TP file. 

For 2022, no doubt only 1 unit will be contemplated on Sch E.  I have to enter the assets anyway so I'll whack them up by unit and suspend deprc on the one not in use. 

Bill, good thought about non-qualified use. I'll revisit it w/ TP and get some  clarity. He did mention he would like to leave it as an inheritance for his daughter, but plans have a way of changing.. For 2022 it won't make a difference since I'm not taking expenses for the unused apartment.

Bob, I'll certainly recommend it amending 20 & 21. (there are other mistakes in the 20 & 21 that will likely result in a notice anyway) If I do it, I'm going to charge them so I prefer that he goes back the the last preparer and have them fix their own mistakes. 

Jensen;  Excellent cite. I didn't think it definitive though, because the Court stated credibility issues with the petitioners, which obviously weighed on the decision. In 2015, I had a client sell a 3 family that truly was used as a 'family' house (never rented in 15+ yrs.). H/W,  5 kids, 2 dogs, & Mother in law.  IRS looked at the return with a CP notice, but allowed the 121. The apartment units were never physically altered.

Rick, in NJ no need to "merge" units unless you want to physically alter the building character; including structural, utilities, maybe remove a kitchen, etc... If attempted, it's a nightmare with the municipality. I've seen a few mixed use buildings turned into all habitational. Truly an ugly process. 

Thanks again for the thoughts.

[BobKamman]

For those who like to throw the book at taxpayers, here's a question.  Suppose you're an IRS special agent working on drug investigations and a credible informant tells you that this guy is selling fentanyl hidden in hollowed-out copies of Pub 17.  You go to the judge magistrate for a warrant to search his "home."  When you get to the property, which units do you enter?

[taxes96786]

How do you expect that to fly? Due diligence says you amend the 2019 return to show that 1/3 out of service on date he stopped renting it. Then you make sure that all returns forward from 2019 the rental expenses for the unit still renting allocated properly by sq ft of that unit. You may have to amend additional returns. This should insure that the figures used to report the sale will be correct.

[TaxGuyBill]

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@Skylane wrote:

Rick, in NJ no need to "merge" units

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But merging them would make it one residence (See example 4 in §1.121-1(e)).  As of now, my interpretation is that the second place is a guest apartment, man-cave, and storage locker, not 'part' of their residence.

[Skylane]

@taxes96786  lol, so it sounds like “Dear TP, while preparing your 2022 returns, I noticed errors in you 2020 and 2021 returns. I am enclosing amendments that will result in additional tax on 750 for 2020 and 625 for 2021. The additional fee is $450. Please sign and return the enclosed documents and with the fee.”

You might check circular 230 for the obligations and requirements of a tax preparer. I prepare tax returns. I do not audit them.

Fwiw, I FLY a PA32/300 and subject to FARs. (Fed aviation regs.). There are many many situations where it is a physical impossibility to comply with some regs without breaking others. The trick is to do it safely.

[Skylane]

@TaxGuyBill  I agree it’s not going to become part of their primary residence unless they significantly change the usage. For the time being I’m considering the unit it as a secondary residence,  We’ll deal the future if they decide to sell, or gift.

Legally converting the the structure from a 3 to a 2 is not goin to be a consideration for a myriad of reasons. 

[BobKamman]

I prepare tax returns too.  I come here to watch other wannabe auditors do their thing.  I often advise clients on what may happen if they do not correct a mistake on a return that is already filed.  If they decide to file an amended return, they can pay me to do that.  If I think they are cheating the government more than the average taxpayer, I can drop them as clients.  Usually they have come to me because they want to get closer to voluntary compliance, and life is too short for me to beat them into submission.