Losing my Tail, Can I Deduct the Loss?

It is not uncommon for a property owner to experience a large loss on the sale of a piece of property. It is also not uncommon that an issue exists regarding character of the loss and whether the asset sold was a capital asset or a business asset used in carrying on a trade or business. The impact on tax liability can be quite large. For example, a taxpayer buys a tremendously expensive historic waterfront mansion to hopefully restore and rent for exorbitant rent amounts during busy seasons. However, the taxpayer never rents out the property. Instead, the taxpayer sells the property taking a seven-figure hit in losses. Given the nature of the purchase and intent for use, the taxpayer reports this massive loss in hopes to mitigate actual losses by an offsetting tax deduction only to have the loss determined to be capital in nature. In that case, the deduction is severely limited. Such was the story in the case of David and Candace Keefe coming out of the Second Circuit.[1]

The Keefes purchased a historic mansion known as the Wrentham House, a historic 14,000 square foot waterfront mansion in Newport, Rhode Island for $1.35 million in January 2000 with the intention of restoring and eventually renting the house to wealthy individuals capable of paying extremely high lease prices. In October 2002, the Keefes divided the property into two parcels, one containing the Wrentham House and the other the Carriage House. The Keefes then sold Carriage House for $950,000 under a declaration of condominium. The sale required that any Wrentham House rentals would require notice to the Carriage House owners. Further, the condo declaration stated that no unit (Carriage House or Wrentham House) could be leased more than one time per calendar year, thus severely limiting income possibility. The Wrentham House remained vacant. However, the Keefe’s borrowed over $9 million at interest rates varying from 3.5% to 25% to renovate the Wrentham House.[2] After years of issues with contractors and subcontractors and pouring a tremendous amount of money into the mansion, the Keefes called it quits and sold in 2009. The property had been listed for sale since 2004. Also, the Keefes never registered the Wrentham House with the city clerk’s office as a short term rental or guest house. The Keefes found some cost mitigation in the form of tax credits. Both state and federal tax credits were available. The Keefes applied for and received the state tax credits, not containing a rental requirement. The federal credits required rental for a period of five years. Those credits were never sought by the Keefes.

In 2006, the Keefes met with a real estate rental agent to discuss the rental of the mansion. The Keefes expected $75,000 per month during the summer and $10,000 per month during the remainder of the year. In 2007, the agent spoke to potential clients, but refrained from posting online due to concerns surrounding whether the mansion would be ready to be occupied. The Keefes expected to be ready in 2008. One person expressed interest, but never entered into any agreement. The Keefes never notified the Carriage House owners of any expectation to rent. After completion of the renovations in May 2008, the property was no longer available for rent. The Keefes finally sold on July 31, 2009 for $6.51 million. At this point, the question was how to treat the loss for taxes.

Originally, in discussing with the Keefes’ tax preparer, the sale was to be reported as the sale of a capital asset. After speaking with an estate planner, the Keefes decided to treat the loss as a sale of business property to take an ordinary loss. After carry-backs of the losses to prior years and a carry-forward to 2010, the aggregate federal income tax liability for all years of $746,445 dropped to $89,171. For the 2009 tax year alone, the income tax liability was $16. In May 2014, the Keefes received their notice of deficiency for tax years 2008 through 2010 for tax deficiencies, penalties, and additions to tax. Particularly, because of the magnitude of the effect of the loss taken as ordinary versus capital, accuracy related penalties applied. Additionally, there were some failure to file and pay penalties as well. The Keefes filed their petition for redetermination with the Tax Court, but the Tax Court agreed with the IRS that the sale was the sale of a capital asset, not a business loss, therefore the loss could not be used to offset ordinary income but was instead a capital loss against capital gains.

The Tax Aspects of the Deal

Basis and Expenses

The Keefes had $751,750 in basis from the allocation of the original acquisition cost plus an increase in basis of $4.5 million for the costs associated with rehabilitating the property. An additional $3.3 million in interest was paid on the associated loans, the treatment of the interest being another issue before the Court.

The Keefes reported an adjusted basis of $10,045,000 upon the date of sale. The Keefes reported a net operating loss, carrying back all the way to 2004, then forward to 2010. Effectively, the reported loss was used against prior years’ income, current year’s income, and the following year’s income, all ordinary. The Second Circuit opinion notes that the Keefes never claimed any depreciation expenses on the Wrentham house, an action someone operating a rental property normally would do.

The Tax Issue: The Character of the Wrentham House in the Hands of the Keefes

The central issue in the case was whether the property was a business asset or a capital asset. A capital asset is property held by a taxpayer (whether or not connected with a trade or business), but that does not include property used in a taxpayer’s trade or business for which depreciation is permitted under IRC § 167.[3] Property held for the production of income, but not used in a trade or business of the taxpayer, is a capital asset subject to the limitations on losses under IRC § 1211(b).[4] For capital asset, a taxpayer is entitled to take losses, however use of such losses are extremely limited against ordinary income. Capital losses are generally applied against capital gains and thus do not yield as much value to taxpayers as ordinary losses which apply to ordinary income, which is taxed at ordinary income rates.[5] Furthermore, it is not uncommon for taxpayers to not have enough capital gains against which to use capital losses, further intensifying the effect of a loss being capital and not ordinary in nature.

To be an ordinary loss (for the Second Circuit specifically here), the taxpayers must be engaged in continuous, regular, and substantial activity in relation to the management of the property to support a conclusion that the property was used in a trade or business and not a capital asset.[6] Gray Edmondson previously wrote in great detail about what a trade or business is and how such is determined.[7]

The Keefe’s Situation – Asset Classification

While the Keefe’s claimed the Wrentham House was an asset used in a rental real estate business, the fact is there was the property was never rented out. Throughout the review of the facts of the case, several items can be noted to support this conclusion:

  1. The Keefe’s never rented the property;
  2. The Keefe’s never registered the property with the city clerk’s office as a short-term rental;
  3. There was never any depreciation expense claimed against the house; and
  4. The condo declaration limited rentals to one rental per year, almost negating the possibility of a rental business.

Based on the facts above, one could reasonably conclude that not only was the rental business never really undertaken; it was not even really feasible. Accordingly, the Second Circuit agreed with the Tax Court. The property was a capital asset and as a result, the loss associated with its disposition was not usable against the Keefe’s ordinary income. The loss could not be carried back. To the extent of any loss which would be used (beyond the $3,000 allowable against ordinary income), it would be applied towards capital gains, usually taxed at about half the rate as ordinary income.

The Interest Expenses

The next issue at hand was whether the interest incurred during the ownership of the Wrentham house should have been capitalized into basis or expensed against ordinary income. IRC § 263A provides that certain direct and indirect costs associated with producing property, including property held for investment, must be capitalized into the property’s basis. Interest is capitalized to the extent it is paid or incurred during the period in which the property is being constructed or produced.[8] Improvements are also capitalized.[9] As the property was a capital asset and not a trade or business asset, the Court concluded that the interest expenses were subject to capitalization and therefore could only be used in calculating the loss following the disposition of the property.

Takeaways

The Keefes situation is tremendously unfortunate. The bad, starting in 2000, turned worse riding through 2008 and into 2009. Add to their peril their failure to timely file tax returns in several of the years at issue, and the loss is just a growing snowball of epic proportions. In short, if a taxpayer wants to claim an ordinary business loss on the disposition of a rental property, the taxpayer should be able to demonstrate and articulate facts supporting their position. These facts would include:

  1. Actual rentals;
  2. No covenants or other contractual limitation limiting the rental usage of the property; and
  3. At least a significant undertaking and substantial efforts to rent the property in question.

If a position is intended to be taken on a tax return, even if suggested by a tax professional, be mindful of something “too good to be true” and be sure that the position can be supported by real, articulable facts demonstrating solid support for the position taken.

The “trade or business” threshold applies in a myriad of additional contexts as well today. Keeping in mind the case at hand involved tax years going back almost 15 years, much has happened in the Code since that time. Miscellaneous itemized deductions are effectively gone, so deductibility of an expense needs to occur through a carrying on a “trade or business.” Other implications beyond the scope of this article exist as well including application of the net investment income tax and qualification for the qualified business income deduction.

[1] Keefe v. Comm’r, No. 18-2357-ag (2d Cir. 2020).

[2] Keefe v. Comm’r, T.C. Memo. 2018-28.

[3] See IRC § 1221(a)(2).

[4] Treas. Reg. § 1.1221-1(b).

[5] Up to $3,000 in capital losses can be applied against ordinary income however.

[6] See Gilford v. Comm’r, 201 F.2d 735,736 (2d Cir. 1953) (the performance of sufficient rental-related activity, either by the taxpayer or an agent of the taxpayer, will support the conclusion that the taxpayer was engaged in a trade or business with respect to the property)

[7] https://esapllc.com/the-importance-of-being-a-trade-or-business/

[8] IRC § 263A(f)(1)(A).

[9] Treas. Reg. § 1.263A-8(d)(3)(i)-(ii).

Joshua W. Sage, J.D., LL.M.

Josh is a partner at ESA Law. Josh practices in the areas of tax, business, and estate planning. View Full Profile.