Home Rentals and the “Master’s Rule”

Take-Away: Often there is the temptation to rent one’s home for a short period of time, especially when there is a strong demand for housing for short period of time. The tax law favors such short-term rentals of a home, but as always there are limits to this opportunity.

Background: There exists an interesting rule in the Tax Code commonly referred to as the Master’s Rule. This rule permits an individual to omit from their taxable income any sums that they obtained from leasing their home, provided that the home is rented for no more than 14 days annually. The name Master’s Rule comes from the frequent exploitation of this unique Tax Code provision by residents of Augusta, Georgia during the annual Master’s Golf Tournament, but this rule is also exploited around other major sporting events like the Super Bowl. The rule, found at IRC 280A(g), provides:

(g) Special rule for certain rental use. Notwithstanding any other provision of this section or section 183, if a dwelling unit is used during the taxable year by the taxpayer as a residence and such dwelling unit is actually rented for less than 15 days during the taxable year, then- (1) no deduction otherwise allowable under this chapter because of the rental use of such dwelling unit shall be allowed, and (2)the income derived from such use for the taxable year shall not be included in the gross income of such taxpayer under section 61.”

The rental income not being included in the owner’s taxable income sounds almost too good to be true. Which is when the old ‘saw’ that pigs get fat, but hogs get slaughtered’ often comes into play. That was the outcome in a recent Tax Court decision.

Sinopoli v Commissioner, Tax Court Memo 2023-105 (August 14, 2023)

Facts: The clever owners (two doctor and a third fellow) combined the Master’s Rule with the rental of their homes by their S corporation for monthly shareholder meetings. (You can see where this is headed.) The strategy pursued was to rent the homes by their S corporation [a Planet Fitness franchise] and then deduct the amounts paid by the corporation as rent. These rent payments by the S corporation would not be taxable on the shareholder’s individual tax returns, and the S corporation would take a corresponding business deduction under IRC 162(a). Over $290,000 was paid by the S corporation in rent for these monthly shareholder meetings over 3 years- 36 months. The ‘meeting space’ was determined by the shareholders to be rented at a rate of $1.83 per square foot, but no rental appraisal was ever obtained to justify this fixed rental amount paid. The rent paid worked out to each shareholder being paid $3,000 in monthly rent by their S corporation for the use of the shareholder’s home for their monthly meeting. Each doctor reported the rent as income on Schedule E of their personal tax return but excluded it from their gross income under IRC 280A(g), claiming that rental income from the rental of the taxpayer’s home is not included in gross income if the residence is rented for no more than 14 days in a taxable year, which was the case. The third shareholder also did not report the rental income for one of the 3 years in question.

IRS Examination: The IRS agent who was assigned to examine the three shareholders’ personal income tax returns researched local rents and determined that the cost to rent a meeting space in the locale that would accommodate 500 to 1,200 people rented for about $500 for a full or half day. Since no meeting notes were provided for 2015, no income tax deduction was allowed for 2015. As for 2016 and 2017 the rent deductions allowed were $6,000 for 2016 and $4,500 for 2017. Unhappy with this result, the shareholders took their case to the Tax Court. Apparently the shareholders were unable to document any shareholder meetings (by virtue of notes taken, calendars, agenda, minutes, etc., so it was pretty much their word that such meetings occurred) for 2015, and only 12 meetings in 2016 and 9 meetings in 2017 were in fact documented.

Tax Court: The Tax Court judge found that the rents paid by the S corporation for the use of the shareholders’ homes for monthly meeting was excessive.

Reasonable and Necessary Expense: IRC 162(a) allows a deduction for ordinary and necessary expenses paid or incurred during a taxable year in carrying on a trade or business are deductible, but only if they are reasonable in amount. The amount of over $290,000 as rent for the shareholders’ residences for these meetings was significantly high, when considering the nature of the meetings,, primarily held between a limited number of individuals and the frequency of only once a month.

Rent Amount: The Court then found that the amount of rent paid was unreasonable. “We agree with respondent [the IRS] that it seems that petitioners adopted a tax scheme to distribute Planet’s earnings to petitioners through purported rent payments, claim rent deductions, and exclude the rent from their gross income relying on section 280A(g). While petitioners argue that the $500 rent determined by [the IRS agent] was not reasonable, we disagree and find to the contrary that $500 allowed per month is actually generous. Obviously, only small portions of the residences were used for the meeting when they occurred.”

Observations: While the Tax Code provides for many deductions and exclusions from income, those provisions do not operate in isolation from one another. While IRC 280A(g) allows for exclusion of rental income, it does so under specific conditions- it is not a blank check to charge any rental rate that the owner wishes without regard to being reasonable, as IRC 162 requires, along with being ‘ordinary and necessary’ in the conduct of a trade or business. One wonders if the outcome might have been more favorable to the three home owners if this had not been a related-party transaction where they controlled both the entity paying rent and the entity receiving the rent, which usually attracts close IRS scrutiny.

Conclusion: Tax-free rental income always sounds nice. It’s just important to be reasonable, not greedy, when the rent is negotiated, or be able to justify the rent charged.