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Renting below FMV may result in lost deductions due to vacation home rules.

The Tax Court recently concluded in Colbert, TC Memo 1992-30, that renting property at below fair market value (FMV) is considered personal use under Sec.

280A(d)(2)(C). This case is significant because the property was not being rented to a family member. Rather, the property was being rented to unrelated low-income persons. While the particular facts in this case might be distinguishable from many rental agreements between landlords and long-term tenants, the case should put practitioners on notice that the Service is challenging deductions related to some below-market rental arrangements. Because of their potential for abuse, rental arrangements between family members may be likely candidates for IRS scrutiny.

In Colbert, the taxpayer acquired rental property by inheritance from his deceased wife. The property was initially rented out by Colbert's wife for $130 per month. After the inheritance, Colbert continued to rent the property for $130 per month to various unrelated "low-income" persons. Colbert paid his mother-in-law to manage the property. In 1987, after Colbert ceased renting to third parties, his mother-in-law resided in the property without charge. Colbert did not argue that $130 per month represented FMV rent; rather, he contended that he was holding the property for investment.

Applying Sec. 280A(d)(2)(C), the court determined that Colbert had personal use of the property during 1982 because the property was rented at rates below FMV and that Colbert's rental expenses were limited under Sec. 280A(e)(1). The court indicated that Colbert's desire to rent to low-income families at reduced rental rates established that he deliberately rented the property at an amount less than FMV. Colbert's reasons for renting the property at rates below FMV were never discussed.

This case highlights an issue that might exist in some rental arrangements in distressed real estate markets. To secure tenants, a landlord might be willing to rent a particular property to an unrelated third party for an amount that is clearly below the then-existing market rate. It would seem extreme that this business decision could result in deduction limitations under the vacation home rules. However, it does serve as a reminder that taxpayers renting property in potentially non-arm's-length situations - such as rental to family members - should secure evidence documenting that the rental arrangement reflects market terms. The Service is likely to aggressively challenge deductions in these situations.
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Title Annotation:fair market value
Author:Dennis, William A., Jr.
Publication:The Tax Adviser
Date:Jun 1, 1992
Previous Article:Special estimated tax rules.
Next Article:IRS investment interest expense ruling applies a very broad interpretation of property held for investment.

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