Use of Management Company Did Not Allow Real Estate Professional to Include Vacation Properties in Rental Grouping under §469(c)(7)
In what may initially seem like an odd argument for both parties to make, the IRS successfully argued that vacation homes were not rentals in the case of Eger v. United States, USDC Northern District California, Case No. 18-cv-00199-DMR.[1]
Greg Eger was a real estate professional, meeting the requirements under IRC §469(c)(7). The Eger owned three properties that were offered for rent at points during the year, located in Mexico, Colorado, and Hawaii. [2] In each case they entered into contracts with management companies that would seek to offer these properties up for rent, although in each case the Egers had the right to remove days from the rental pool for their own personal use.[3]
The agreement with the management company for the property in Mexico was described as follows:
The Egers entered into a “2006 Consulting Agreement” with SH Consulting, LLC (“SH”) to rent out and manage the property (the “Mexico Agreement”), pursuant to which SH was granted the “exclusive right to market [the Mexico Property, hereinafter “the Unit,”]3 to third parties for use.” [Docket Nos. 43 (2-7), 44-48 (Declaration of Smith (“Smith Decl.”)), Ex. 8 at ¶ 2.] As part of the agreement, the Egers elected to join a program called “Free Sell.” Under the Free Sell program, SH would “black out any and all dates that [the Egers] do not wish to offer the Unit for use.” Id. ¶ 3. The Egers could update the blackout dates at any time in writing, as long as there was not a conflicting confirmed reservation for the Unit. Id. SH agreed to use its efforts to market the Unit “for use by third parties on the Available Days,” and was allowed to “enlist the services of one or more subcontractors or other third parties to assist SH in such efforts.” Id. ¶ 6. SH was also entitled to request up to five complimentary nights from the Egers. Id. ¶ 7. SH would execute a “Use Agreement” with third-party guests who wanted to rent the Mexico Property, and could make changes to the Use Agreement as SH “deemed appropriate,” except that SH could not change the daily use fee without the Egers’ consent. Id. ¶ 8. SH was authorized to collect payment from third-party guests and allocate 70% to the Egers and 30% to SH, after subtracting service fees. Id. ¶ 9. The Egers occupied the Mexico Property for 13 nights in 2007, 12 nights in 2008, and 12 nights in 2009. JS ¶ 24.[4]
The agreement for rental of the Colorado property was described as follows:
The Egers entered into a “Rental Program Agreement” (the “Colorado Agreement”) with Bachelor Gulch Operating Company, LLC, which was labeled as “Resort Owner” in the agreement. Smith Decl., Ex. 15. Pursuant to the Colorado Agreement, the Resort Owner owned the resort under the Ritz-Carlton name. Id. at 1. The Egers could elect to place their property into a “voluntary rental program” to rent the Unit to “guests of the Resort.” Id. By opting into the rental program, the Egers allowed the Resort Owner to “act as the sole and exclusive rental agent to offer the Subject Unit for rental.” Id. The Colorado Agreement granted the Resort Owner “the exclusive authority to rent, operate and manage the [ ] Unit as agent of Unit Owner.” Id. at 2. The rental program placed the Unit in a rotating unit reservation system “designed to fairly and equitably allocate Unit reservations and occupancy among Participating Units.” Id. The Resort Owner was responsible for “rent[ing] the [ ] Unit to Resort Guests on a transient basis for and on behalf Resort Owner (sic) and [the Egers],” and for collecting the owed amounts from the guests. Id. at 3. The Resort Owner would also help market the Unit; provide a central reservation system for the entire Resort and process all reservations received through this system; and negotiate all terms and conditions including setting room rates, negotiating group rates, and offering incentives to prospective guests. Id. The Resort Owner was responsible for setting the rental rate for the Unit and could modify the rate at its “sole and absolute discretion.” Id. at 7. The Resort Owner was also entitled to seven complimentary nights, to be used at its discretion. Id. The Egers had the right to use the property subject to several restrictions. First, they were allowed to request the Unit for up to 56 nights in a calendar year. Id. at 8. Anything beyond the 56 nights would be subject to an additional fee owed to the Resort Owner. Id. at 5. The Egers could not reserve the Unit more than 365 days in advance. Id. at 8. If the Egers were to reserve their Unit, they would have to register at the Resort. Id. at 9. If any guests were to stay with them in their Unit, they would have to notify the Resort Owner of the names and occupancy dates of all guests no less than 15 days prior to the date of arrival of any such guest(s). Id. The Egers could not accept payment or other consideration for the use of the Unit during any nights on which they decide to use the Unit. Id. They could not enter the Unit without prior notification, approval from, or coordination with the Resort Owner, and could not make alterations to the Unit. Id. at 11-12. The Egers never occupied the Colorado Property during the Relevant Years. JS ¶ 25.[5]
And, finally, the taxpayers entered into the following agreement with regard to the property in Hawaii:
They entered into a “Rental Program Agreement” (the “Hawaii Agreement”) with Honolua Associates, LLC to rent out and manage the property for the Egers. Smith Decl., Ex. 28. Pursuant to the Hawaii Agreement, the management company became the exclusive rental agent, and agreed to “endeavor to offer for rent” the Unit “to Resort Guests on a transient basis for and on behalf of [the Egers].” Id. at 4. As with the Colorado Property, the management company was responsible for collecting room rental from guests and marketing the Unit under the Ritz-Carlton name. Id. at 5. Indeed, the Hawaii Agreement is substantially similar to the Colorado Agreement, with two notable differences. First, unlike the Colorado Property, there was no limit on the number of nights the Egers could reserve the Hawaii Property, except that in the initial six months the Egers were subject to a 30-night cap. Id. at 10-11. Second, the Egers had to reserve use of the Unit at least 180 days in advance, id., while the Colorado Agreement required that they make reservations no earlier than 365 days in advance. The Egers never occupied the Hawaii Property during the Relevant Years. JS ¶ 26.[6]
Mr. Eger sought to group the three properties together, having made the election to treat all of his rental properties as a single activity per IRC §469(c)(7), which included 30 other properties in addition to these three.[7] By making such a grouping, it becomes much easier to qualify for material participation under §469, since all hours of participation in any of the rentals counts towards showing material participation in the activity as a whole.
But the IRS objected to the inclusion of the three rentals described earlier, arguing that, for purposes of IRC §469, they were not rental properties.
The IRS argued that the arrangements were such that the properties were excluded from being treated as a rental activity by Reg. §1.469-1T(e)(3)(ii)(A) since it met the “less than seven days” test.[8] The regulation states:
(ii) Exceptions. For purposes of this paragraph (e)(3), an activity involving the use of tangible property is not a rental activity for a taxable year if for such taxable year -
(A) The average period of customer use for such property is seven days or less;
Initially, the fight revolved around who was the customer in this case. As the opinion notes:
The Government contends that this exception applies to the three properties at issue because the average period of customer use for each of them was seven days or less. See, e.g., Def.’s Opp’n & X-Motions at 4. Under the Government’s approach, the customers are the end-user guests who stayed in the rental properties. According to the Government, the IRS correctly determined that the three properties do not constitute rental activity because the end-user guests stayed an average of less than seven days. For their part, the Egers assert that the customers are the three management companies with whom the Egers had a contractual relationship. See, e.g., Pltfs’ Mot. at 12. Therefore, according to the Egers, the average period of customer use was far greater than seven days, which means that the exception does not apply, and they appropriately treated the three properties as rental activity in their tax returns.[9]
The District Court found, however, that even if you viewed the management companies as the customer, the taxpayers still failed the seven-day test. The retained rights the Egers had to use the property meant that the management companies did not actually have a continuous or recurring right to use the property when applying the test at Reg. §1.469-1(e)(3)(iii)(D) which provides for measuring the period of customer use.
The taxpayers had cited the cases of White v. Commissioner, TC Summary Opinion 2004-139, and Hairston v. Commissioner, TC Memo 2000-386 to show the management company should be treated as the customer rather than the end-user under an arrangement similar to theirs. But the District Court found that there was an important difference between their agreements and those in the cited cases, noting:
White and Hairston are distinguishable from this case because the taxpayers in those cases entered into contracts that conveyed exclusive access to their properties, including the right to rent to third party end-users. See White, 2004 WL 2284383, at *5; Hairston, 2000 WL 1862902, at *2. The taxpayers in White and Hairston did not retain any rights to use their properties throughout the duration of the agreements. By contrast, the Egers retained significant rights to use the Resort properties and therefore did not convey exclusive access rights to the management companies.[10]
The opinion continues:
The language of the management agreements lend support to the court’s conclusion that the management companies were not customers who had a continuous right to use the Resort Properties. Rather, the management companies provided marketing and rental services for the Egers to rent out the Resort Properties. The agreements state in relevant part that the companies entered into contracts to rent out the Resort Properties on behalf of the Egers.Smith Decl., Ex. 8 at 1 (allowing the company “exclusive right to market [the Mexico Property] to third parties for use”); Ex. 15 (Colorado Agreement) at 3 (the company was responsible for “rent[ing] the [ ] Unit to Resort Guests on a transient basis for and on behalf [of the management company] and [Plaintiffs]”); Ex. 28 (the Hawaii Agreement) at 4 (company provide the service of “endeavor[ing] to offer for rent” the property “to [end-user guests] on a transient basis for and on behalf of [Plaintiffs]). In sum, the record demonstrates that the management companies did not have the continuous right to use the Resort Properties.[11]
The Court also found that the math didn’t work if you tried to argue that they had recurring use in excess of seven days.
…[E]ven if the court were to find that exclusive control over the right to rent out the Resort Properties constitutes a “recurring right” to use them, the Egers have not demonstrated that the average period of customer use is more than seven days for each of them. This is because the Egers’ retained rights to use the Resort Properties throughout the Relevant Years exceed 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 results in an annual average period of use of less than seven days. The Egers again respond that the court should look to actual conduct to determine whether the managing companies had a recurring right. They point to the fact that they never used the Colorado and Hawaii Properties, and only exercised their right as to the Mexico Property for a few nights each year. According to the Egers, by those calculations, the management companies’ recurring use would be more than an average of seven days per year. This “actual conduct” argument fails here for the same reasons as discussed above, because the regulations clearly discuss a right to use the property, rather than actual use. In sum, the Egers have not provided legal or factual support for their position that the management companies had a “recurring right to use” the Resort Properties.[12]
The Court found that the taxpayers had attempted to take the results in the cases they cited further than they could be taken. The key factors the Court focused on were that:
The management companies had only the right to attempt to rent out the properties for the taxpayers, not the right to use the properties, including the right to sublease them and
The taxpayers’ retained rights (even if not used) to use the property got in the way of being able to show the right to use the property for more than seven days.
The bottom line is that the IRS did what litigants virtually always will do when the other party cites a case—work to show how the facts in the cited cases are different from the situation currently before the Court. That’s much simpler (and far more likely to succeed) than attempting to argue there was an error made by the earlier court in its findings since cases are always distinguishable in some manner. So the question then moves to why the differences do or do not matter.
When planning with a client, if the position relies upon case law it’s very important to fully understand the facts of the case that was decided, as well as objectively look at the differences in your client’s situation. Too often we read a summary or article (like this one), and believe we know what need to know to take action. In reality, no summary or article can cover all details, nor does the author of the summary or article know your client's facts. That’s why it’s so crucial to actually read the underlying case and understand how an adverse party (most often the IRS) could use the differences in the facts to overcome the case law that you believe supports the taxpayer’s position.