1973, April, Pg. 1. Deductibility of Expenses Incurred in Rental of Vacation Homes.

• Author: by Samuel P. Guyton

2 Colo.Law. 1

The Colorado Lawyer

1973.

1973, April, Pg. 1.

Deductibility of Expenses Incurred in Rental of Vacation Homes

1Vol. 2, No. 6, Pg. 1Deductibility of Expenses Incurred in Rental of Vacation Homesby Samuel P. GuytonStatistics reveal that in Colorado as in other parts of the country there has been a marked increase in the number of second homes which are being acquired. Investment, production of income and recreation appear to head the list of reasons why owning a second home has become so popular. Owners of such homes, which will be referred to as "vacation homes" since they are usually located in recreation areas, frequently rent their homes to third persons for a portion of the year either to realize a profit on the rental activity or to attempt to reduce the expenses of ownership. This article presents the general parameters of the deductibility of vacation home expenses for federal income tax purposes and examines how the 1969 Tax Reform Act and the Treasury Regulations thereunder may affect the deduction of such expenses.

Rules Prior to 1970Prior to 1970, owners who rented their vacation homes to third persons but made no personal use of their homes were generally permitted to deduct for federal income tax purposes all expenses, including depreciation, incurred in operating and maintaining the homes.(fn1) In many instances, however, the owners occupied the homes for part of the year and rented them to third parties for the rest of the year. Where there was this division of personal and rental use of such homes, owners were generally permitted to deduct the proportionate part of the operating and maintenance costs which related to the rental use, although no deduction was allowed for the portion of the cost pertaining to personal use of such homes.(fn2) Thus, if there was one-third personal use and two-thirds rental use of a vacation home, the owner was usually permitted to deduct two-thirds of the maintenance and related expenses, including depreciation, for operating the home. Such deductions were claimed under section 162(a) or 165(a) of the 1954 Internal Revenue Code as expenses or losses incurred in a trade or business or under section 212 of the 1954 Code as expenses incurred for the maintenance of property held for the production of income.

Carkhuff CaseThese general rules regarding deductibility of vacation home expenses where there is a joint personal and rental use of the home were significantly narrowed in Carkhuff v. Commissioner, 425 F. 2d 1400

2(6th Cir. 1970). In this case, which dealt with the purchase of a vacation home at Sea Island, Georgia, for $140,000, the owners reserved the home for their personal use for one-third of the year and made it available for rental to third parties for two-thirds of the year at a monthly rental of $1,300. The owners originally allocated one-half (instead of two-thirds) of their total maintenance and operating expenses, including depreciation, to rental use and claimed such amount as deductions, which resulted in losses of $3,912.60, $5,088.05 and $7,495.80 for 1962, 1963 and 1964. The Internal Revenue Service disallowed the deduction of such losses and in a memorandum decision the Tax Court(fn3) upheld this disallowance on the grounds that the taxpayers had not established that they acquired the home with the intent to make a profit and that after acquisition the home had not been converted to a profit-motivated activity. In viewing the facts of the case, the Sixth Circuit affirmed the Tax Court decision and held that the losses incurred from the rental use of the home were not deductible under either section 162 or section 212 since the home had not been acquired or operated with a profit intention, and therefore not even the portion of the losses attributable to rental use was deductible. Further, the Court held that no allocation of expenses between personal and rental use could be made since the predominant purpose and use of the house was for recreation and pleasure. This ruling was based upon the Court's finding that the owners had used the house personally in two out of four peak vacation months, that the rental activity was not carried on primarily to make a profit or as an income-producing operation in view of the magnitude of losses and the owners' financial status, and that the company which listed the house for rent was not primarily interested in renting the owners' house, but in attracting guests to the Sea Island resort.

Section 183---General RulesIn the tax reform movement of 1969, Congress repealed section 270 and added section 183 to the 1954 Internal Revenue Code concerning the deductibility of expenses incurred after 1969 with respect to activities not engaged in for profit.(fn4) In essence section 183 codifies the majority position enunciated by the courts in the hobby loss cases, which was that losses were not deductible under sections 162(a) or 165(a) of the Code unless the taxpayer had a bona fide expectation of making a profit from the activity. Thus, the general rule under section 183, which applies to all activities, is that losses are not deductible unless the activity is engaged in for profit. The legislative history of section 183 makes it clear that the key criteria in showing the requisite profit motive are the objective facts and the circumstances of each particular case.(fn5) Section 183 is broad in scope in that it applies to all activities engaged in by an individual or a Subchapter S corporation. Although corporations are not subject to section 183, the legislative history of this section reveals that the omission of corporations should not be inferred to mean that an activity of a corporation may or may not be engaged in for profit.(fn6)

Furthermore, section 183 contains a unique provision in favor of the taxpayer since it states that there is a rebuttable presumption that an activity was engaged in for profit if the taxpayer can show a profit in at least two out of five consecutive taxable years ending with the taxable year in question. Since this is a rebuttable presumption, the IRS has the right to try to establish that, regardless of the presumption, the facts show that the taxpayer was not engaged in an activity for profit. The 1971 Revenue Act added a new subsection (e) to section 183 clarifying this presumption, which states that a taxpayer initially entering an activity has five years (seven years in the case of certain horse operations) in which to have two profit years and have the presumption apply to all years in the initial five- or seven-year period. Of course, a timely election must be made by the taxpayer to waive the

3statute of limitations and suspend application of the presumption rule until the end of the five- or seven-year period, although Regulations describing how this election should be made have not yet been issued. Thus, a taxpayer initially entering an activity, such as renting a vacation home, has five years in which to have two profit years in order for the presumption rule...