Using Property Management Company to Rent Properties Precluded Loss Deductions

(Parker Tax Publishing August 2020)

The Ninth Circuit affirmed a district court and held that a couple could not treat the operation of three rental resort properties as a rental activity under Code Sec. 469 and, thus, the losses associated with those properties were treated as passive activity losses. The court rejected the couple's argument that the property management companies that marketed and rented the properties were the "customers" for purposes of determining whether the average stay by customers was greater than seven days, as required by Reg. Sec. 1.469-1T(e)(3)(i). Eger v. U.S., 2020 PTC 242 (9th Cir. 2020).

Background

Greg and Julie Eger owned numerous rental properties, including three properties located in Mexico, Colorado, and Hawaii (the resort properties). In 2007 through 2009, for each of the resort properties, the Egers entered into management agreements with property management companies.

The agreement for the Mexico property gave the management company the exclusive right to market the property to third parties for use. The Egers could use the Mexico property any time unless there was a conflicting reservation. The Egers occupied the Mexico property for 13 nights in 2007, 12 nights in 2008, and 12 nights in 2009. For the Colorado property, the rental agreement gave the management company the right to act as the sole and exclusive rental agent, and the management company helped market the unit, processed all reservations, and negotiated all terms and conditions including room rates. The Egers never occupied the Colorado property during the years at issue. The rental agreement for the Hawaii property was substantially similar to the Colorado agreement, except there was no limit to the number of nights the Egers could reserve the Hawaii property and the Egers had to reserve the Hawaii property 180 days in advance.

Greg Eger qualified as a real estate professional (REP) under Code Sec. 469(c)(7) during 2007-2009. If a taxpayer qualifies as an REP under Code Sec. 469(c)(7), rental activity is generally not considered passive and losses from such activities can be applied against nonpassive income. Rental activity is defined in Code Sec. 469(j)(8) as any activity where payments are principally for the use of tangible property. Under Reg. Sec. 1.469-1T(e)(3)(i), an activity is not a rental activity if the average period of customer use for the property is seven days or less. A period of customer use is defined in Reg. Sec. 1.469-1(e)(3)(iii)(D) as each period during which a customer has a continuous or recurring right to use the property.

The Egers elected on their 2007-2009 tax returns to group their rental properties, including the resort properties, as a single rental real estate activity. The inclusion of the resort properties increased the total amount of business losses reported on their tax returns and the Egers claimed they were owed a refund. The IRS denied the refund claim after determining that the Egers could not group their resort properties with their other real estate rental activities. The IRS characterized the resort rental activity agreements as "marketing agreements," which were entered into for providing compensation to the management companies for services provided. According to the IRS, the Eger's argument that the management contracts constituted sub-leases of the properties to the management companies was not supported by the facts. The Egers appealed the denial of the refund claims in district court.

The district court agreed with the IRS and denied the refund claims. The court held that the management companies did not have a continuous or recurring right to use the resort properties because the Egers retained significant rights to use the properties throughout the relevant years. The court found that in cases where the period of continuous or recurring use was calculated based on the use by the property management companies rather than that of the end-users, the taxpayers had entered into contracts that conveyed exclusive access to their properties and did not retain any rights to use their properties throughout the duration of the agreements. The court found that, by contrast, the Egers retained significant rights to use the resort properties. The court also rejected the Egers' argument that the management companies' use of the Colorado and Hawaii properties was continuous because the Egers never used those properties during the years at issue, noting that Reg. Sec. 1.469-1(e)(3)(ii)(A) refers to the customer's right to use the property, not the property's actual use.

The Egers appealed to the Ninth Circuit. The sole issue before the Ninth Circuit was whether the Egers' operation of the vacation properties was a rental activity under Code Sec. 469. The parties disagreed on who the relevant "customer" was for the vacation properties. The government argued that the individuals who actually rented out the properties were the customers, while the Egers said the customers were the management companies that took care of, and rented out, the vacation properties for purposes of calculating the average period of use.

Analysis

The Ninth Circuit affirmed the district court and held that the operation of the vacation properties by the Egers was not a rental activity and thus the couple could not deduct the losses relating to those properties on their tax returns. The question of who is properly considered the customer, the court noted, is critical in resolving the issue because the Egers were not arguing that the renters used the property for an average of more than seven days. Because neither the Code nor regulations defined "customer" for this purpose, the court looked to the ordinary, contemporary, and common meaning of the term. When deciding who is a customer between individuals paying to stay in a property and the company responsible for marketing the property and managing payments, the court noted that few people would argue it is the latter. Thus, the court concluded that the individual paying to use the property is the customer and the management companies were not considered "customers." Because the Egers did not attempt to prove that the average stay by renters was greater than seven days, the court held that summary judgment in favor of the government was appropriate.

For a discussion of the rules relating to the grouping of rental real estate activities, see ¶247,110.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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