Rental Properties Subject to Management Agreements Can't be Grouped with Other Rental Activities

(Parker Tax Publishing September 2019)

A district court held that a taxpayer who qualified as a real estate professional under Code Sec. 469 and who entered into contracts with property management companies with respect to three properties owned by the taxpayer could not group the properties with his other real estate properties as a single rental activity for purposes of Code Sec. 469 because the management companies did not have a continuous or recurring right to use the properties as required by Reg. Sec. 1.469-1(e)(3)(iii)(D). The fact that the taxpayer rarely or never actually used the properties during the years at issue was irrelevant, according to the court, because a period of customer use is defined by the right to use the property, not its actual use. Eger v. U.S., 2019 PTC 334 (N.D. Cal. 2019).

Background

Greg and Julie Eger owned numerous rental properties, including three properties located in Mexico, Colorado, and Hawaii (the resort properties). 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 could request the Colorado unit up to 56 nights per year and could not reserve the unit more than 365 days in advance. 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, the years at issue. 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 rejected the refund claim after determining that the Egers could not group their resort real estate rental activities with their other real estate rental activities. The IRS rejected the Egers' argument that the resort rental activity agreements constituted leases, and instead characterized them 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 constitute sub-leases of the properties to the management companies was not supported by the facts. In September 2013, the Egers filed amended returns seeking a refund for the years at issue, but the IRS denied their refund claim. The Egers appealed the denial in a district court.

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 IRS argued that the customers using the resort properties were the end-users, not the management companies, and the end-users' average period of customer use was seven days or less. The Egers asserted that the management companies were the customers and that the companies had a continuous or recurring right to use the properties as a result of their exclusive rights to rent them. The Egers pointed out that they never used the Colorado and Hawaii properties during the years at issue and used the Mexico property for only a few nights during each of the years. The Egers further argued that if the management companies' use was not continuous, it was recurring as a result of their exclusive control over renting out the properties.

Analysis

The district court upheld the denial of the Egers' 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 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 court found that, even if the management companies always had significant rights to use the properties and contracted exclusively with the Egers, it did not necessarily follow that the companies had a continuous right to use the properties. The court found that the management agreements supported its conclusion that the management companies were not customers who had a continuous right to use the properties because under the agreements, the companies provided marketing and rental services for the Egers to rent out the properties. The court noted that the agreements stated that the companies agreed to rent out the resort properties on behalf of the Egers.

Observation: The court said that the question of whether the management companies or the end-users were the Egers' customers was beside the point. The key question, in the court's view, was not whether the management companies were the Egers' customers but whether the companies had continuous or recurring use of the properties for an average of more than seven days.

The court also found that the Egers failed to establish that the average period of customer use should be determined by examining the management companies' recurring right to use the resort properties. In the court's view, the companies' exclusive control over renting out the properties did not amount to a recurring right to use them. The court added that, even if exclusive control over the right to rent out the properties constituted a recurring right to use them, the Egers did not demonstrate that the average period of customer use was more than seven days for each of them. This was because, according to the court, the Egers' retained rights to use the resort properties exceeded the seven-day average as a simple mathematical proposition. Specifically, the Egers retained the right to use the Mexico and Hawaii properties for an unlimited number of days. With respect to the Colorado property, the Egers retained the right to use it for up to 56 nights, which, according to the court, resulted in an annual average period of use of less than seven days.

For a discussion of the tax treatment of trades or businesses that are passive activities, see Parker Tax ¶143,530. For a discussion of the rules that apply when rental property is used for personal purposes, see ¶86,110. 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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