6th Circuit allows rental losses under sec. 280A.

The Sixth Circuit, in Razavi, 74 F3d 125 (1996), rev'" TC Memo 1993-624, ruled that taxpayers who leased their condominium to a company that subleased it to third parties for 200 days could deduct their rental losses from the condominium even though they had personally used it for 27 days. The Tax Court had disallowed the losses, ruling that the Razavis' personal use had exceeded the limits of Sec. 280A(d). The Court of Appeals' opinion is the first in which a court ruled that the days a rental unit is unoccupied can be counted as days in which the unit is rented at fair value in determining if a taxpayer can deduct rental losses.

Sec. 280A(c) (5) disallows the deduction of rental losses if a taxpayer uses a dwelling unit during the tax year as a residence. Sec. 280A(d) specifies that a dwelling unit is used as a residence if the use of the unit by the taxpayer or his family for personal purposes exceeds the greater of 14 days or "10 percent of the number of days during such year for which such unit is rented at a fair rental."

In 1985, Mehdi and Alexandra Razavi purchased a condominium for $355,000 in South Seas Plantation (SSP) in Florida. SSP offered to lease the condominium from the Razavis under two optional lease plans. Under the first, SSP would pay them $21,000 annual rent plus 40% of the annual gross rents in excess of $52,500; the $21,000 was guaranteed even if SSP did not rent the condominium to any third parties. Under the second, SSP would rent out the condominium and pay the Razavis 50% of the gross rents collected with no guaranteed paymeet. Under both plans, the Razavis could use the condominium for a maximum of four weeks per year for $10 per day.

The Razavis chose the first plan. They signed a 30-month lease in February 1986. In 1986, SSP rented the Razavis' condominium to third parties for 149 days and received $29,559; SSP paid the Razavis $19,250 (11/12 of $21,000). In 1987, SSP rented the condominium to third parties for 200 days and received $48,328; SSP paid the Razavis $21,000. The Razavis used their condominium for 36 days in 1986 and 27 days in 1987.

The Razavis deducted rental losses from the condominium in 1986 and 1987. The IRS disallowed the losses, determining deficiencies of $20,309 in 1986 and $11,123 in 1987. The Service argued that the language of Sec. 280A(d) required the Razavis to count only the number of days SSP subleased the condominium to third parties as days when it was rented at "fair rental"; under this standard, they exceeded the 10% personal use. The Razavis argued that they had rented the condominium at a fair rental for most of 1986 and all of 1987, less only the days they personally used it, because of the guaranteed payments they had received from SSP.

The Razavis' expert witness testified that owners of similar condominiums received annual rental income ranging from $19,919 to $24,976. These amounts reflected 39%-49% occupancy rates; most of the units examined had lease agreements under SSP's second plan, under which the owners received 50% of the gross rents. The expert concluded that the $21,000 received by the Razavis was a fair rental for the condominium for a year. The IRS did not present any expert testimony on the condominium's fair rental value.

The Tax Court ruled that the unoccupied days did not count under Sec. 280A(d) as days for which the unit is rented at fair rental. Therefore, because their personal use exceeded 10% of the days the unit was rented to third parties, the Razavis' condominium was a residence under Sec. 280A.

The Tax Court based its ruling on the language of Sec. 280A and two previous c4'es. In Fine, 647 F2d 763 (7th Cir. 1981), the taxpayer placed his rental unit in a rental pool. He was paid a limited amount for each day it was available for rent and a larger amount for each day it was rented to third parties. In Byers, 82 TC 919 (1984), the taxpayers became limited partners in a partnership that rented out units made available by their owners to a rental pool operated by the partnership. The rental unit owners (limited partners) were allocated earned rental income and losses based on a predetermined formula that considered the type of unit owned (e.g., a one-bedroom), not the number of days a particular unit was rented to third parties. The distributive share of rental income and losses allocated to owners was based on the average profit the partnership earned from the rental to third parties of all of the units of a given type. The courts in Fine and Byers pointed out that the method used to allocate the pooled rental income among the owners was irrelevant for Sec. 280A purposes. The courts in both cases then ruled that the units were rented at fair value only on the days they were rented to third parties.

The Razavis appealed the Tax Court ruling for 1987 only, because (regardless of how the court had ruled on the counting of the fair rental days) the Razavis' personal use exceeded the 10% limitation for 1986. The Court of Appeals ruled that SSP's $21,000 annual rental payment to the Razavis was fair rental for the entire year. The court found that the expert witness's uncontradicted testimony proved that this amount was within the range of annual rental income generated by owners of comparable units. Although the Razavis might have received more rent by renting their unit on a daily or weekly basis, Sec. 280A does not require taxpayers to accept the risk associated with short-term rentals. Finally, the court distinguished Fine and Byers: In both cases, the taxpayers "received a greater payment when the units were rented." However, the Razavis received the same payment, regardless of whether their unit was rented to third parties. Although they would have received a larger payment if the rent had exceeded $52,500, the court pointed out that this had never happened.

Razavi provides taxpayers with an opportunity to structure the lease of a dwelling unit so that they can deduct losses while using the unit personally for a longer period than allowed under previous cases. The most cautious approach in following the Sixth Circuit's ruling would be for the taxpayer to receive only a guaranteed lease payment, with no possibility of receiving a larger amount regardless of the occupancy rate.

Two additional points should be noted. Razavi is binding only in the Sixth Circuit states of Michigan, Ohio, Kentucky and Tennessee. Also, rental losses not considered "residential" (and therefore not disallowed under Sec. 280A) would nonetheless be subject to the Sec. 469 passive activity loss limitations.

FROM PETER C. BARTON, CPA, MBA, J.D., PROFESSOR OF ACCOUNTING, UNIVERSITY OF WISCONSIN-WHITEWATER, WHITEWATER, WISC.