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] The taxpayer’s attempt to get the decision overturned on appeal failed when the Ninth Circuit affirmed the District Court decision.[2]

Original District Court Decision

We discussed this case when the District Court rendered its decision in 2019, details of which can be found in the article published on the Current Federal Tax Developments website.[3] Quickly summarizing, the taxpayers were real estate professionals who attempted to include in their rental grouping three vacation homes that they registered to be rented through agreements with management companies.

The IRS argued that these properties were not rentals of real estate as their average period of use by a customer was less than seven days. Under Reg. §1.469-1T(e)(3)(ii)(A) such property rented to customers for an average use period of less than seven days would not be rental real estate. Taking this property out of the grouping with other rental properties would cause the vacation home activity to fail to meet any of the requirements to show material participation.

The taxpayer argued that the IRS was looking to the wrong party as the customer—that it was the time period the property was available for the management company to rent that should be measured, as the management company was the customer. The Tax Court disagreed, finding the management company simply acted as the taxpayer’s agent and the individuals who booked time in the vacation home via the management company were the customers.

The taxpayer decided to appeal the decision to the Ninth Circuit Court of Appeals.

Ninth Circuit Decision

The Ninth Circuit began its review by noting that the term “customer” is not defined in the IRC or the Regulations, deciding that in such a case the common meaning controls:

Because neither the Code provisions nor Treasury regulations at issue define “customer,” we interpret words “as taking their ordinary, contemporary, common meaning.” Perrin v. United States, 444 U.S. 37, 42 (1979). 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, few people who are not creative tax lawyers would argue it is the latter.[4]

The panel also found that looking at the term in the context of how the term is used in the regulation leads to the same result:

Moreover, we must read this regulation, and the term “customer,” “in their context and with a view to their place in the overall statutory scheme.” Wilderness Soc’y v. United States FWS, 353 F.3d 1051, 1060 (9th Cir. 2003) (quoting FDA v. Brown & Williamson Tobacco Corp., 529 U.S. 120, 133 (2000)). As discussed above, the Code definition of “rental activity” is “any activity where payments are principally for the use of tangible property.” 26 U.S.C. § 469(j)(8). So the payment is tied to the “use” of the property. The regulations then state that “rental activity” is generally when “tangible property held in connection with the activity is used by customers or held for use by customers.” 26 C.F.R. § 1.469-1T (e)(3)(i)(A). Reading these provisions together, the individual paying to use the property is the “customer.” In this case, it is the renters, not management companies, paying to use the properties.[5]

The Ninth Circuit noted that the taxpayer’s agreement with the management company was also consistent with the view that the management company simply operated as the taxpayer’s agent:

Appellants’ agreements with the management companies show that they were intended to pay the management companies a percentage of rent received at the vacation properties in exchange for services the management companies provided. The management companies acted as Appellants’ representatives, not customers of the properties.[6]

For completeness, the panel looked to the dictionary definition of a customer:

Finally, we reach the same conclusion when consulting dictionary definitions of “customer,” which is appropriate to better understand the plain language of the regulations. See Af-Cap Inc. v. Chevron Overseas (Congo) Ltd., 475 F.3d 1080, 1088 (9th Cir. 2007). The American Heritage dictionary defines a “customer” as “one that buys goods or services.” The American Heritage Dictionary of the English Language 450 (4th ed. 2000). The most relevant definition in Black’s Law Dictionary is similar, saying a customer is “[a] buyer or purchaser of goods or services; esp., the frequent or occasional patron of a business establishment.” Customer, Black’s Law Dictionary (11th ed. 2019). These dictionary definitions further support the conclusion that the renters of the vacation properties were the customers, because they were the ones actually purchasing a service, as opposed to the rental companies who were themselves being paid for providing a service to Appellants.[7]

Not surprisingly, the Ninth Circuit panel did not find in favor of the taxpayer, stating “[a]ppellants have not demonstrated that the use of the properties fell within the definition of ‘rental activity.’”[8]

[1] Eger v. United States, USDC Northern District California, Case No. 18-cv-00199-DMR https://ecf.cand.uscourts.gov/doc1/035118366526, August 30, 2019, Pacer registration required

[2] Eger v. United States, CA9, Case No. 19-17022, August 13, 2020 https://cdn.ca9.uscourts.gov/datastore/memoranda/2020/08/13/19-17022.pdf (retrieved August 15, 2020)

[3] Ed Zollars, CPA, “Use of Management Company Did Not Allow Real Estate Professional to Include Vacation Properties in Rental Grouping under §469(c)(7),” Current Federal Tax Developments Website, September 4, 2020 https://www.currentfederaltaxdevelopments.com/blog/2019/9/4/use-of-management-company-did-not-allow-real-estate-professional-to-include-vacation-properties-in-rental-grouping-under-469c7 (retrieved August 15, 2020)

[4] Eger v. United States, CA9, Case No. 19-17022, p. 4

[5] Eger v. United States, CA9, Case No. 19-17022, pp. 4-5

[6] Eger v. United States, CA9, Case No. 19-17022, p. 5

[7] Eger v. United States, CA9, Case No. 19-17022, pp. 5-6s

[8] Eger v. United States, CA9, Case No. 19-17022, p. 6