Tax Court and IRS disagree on safe harbor rule

In the 1976 thriller “Marathon Man,” a gruesome scene involved Laurence Olivier’s character Szell, a Nazi war criminal, asking Dustin Hoffman’s character, Babe, “Is it safe?”

Babe blundered into this mess after his spy brother died in his arms. Szell wondered whether Babe knew of his plan to retrieve diamonds stolen during the war.

As Szell repeatedly inflicted pain with dental instruments, Babe said whatever he thought would spare him. “It’s so safe you wouldn’t believe it.” Then, “No, it’s not safe.”

We all want to be safe. But sometimes it’s hard to figure out how to be safe. Such is the fate of those trying to qualify rental property for the tax law’s 20% deduction for “qualified business income.”

The deduction requires that the income be earned from operating a business. Not an investment. The distinction is often hard to determine.

The IRS does not like the idea that a house, or even a few houses, could qualify as a business if rented. Business status confers a few tax benefits not available to an investment.

The IRS developed a rule that would allow a rental to be a business. IRS-developed rules are not the law. But the IRS can say, if you do the following things, you’ll be safe. So, we call these safe harbors.

While you’re in this harbor, no harm can come to you. You can float on your raft, free of all worry. Leave the harbor, and the seas may become dark and foreboding. Some may perish.

The IRS safe harbor says that you must spend at least 250 hours on the rental “enterprise” during the year. “You” can include employees and independent contractors.

Once the activity has been in existence for four years, you can be safe if you meet the 250-hour threshold in three of the five years ending with the year at issue.

Your “enterprise” can, at your choosing, include multiple rentals. However, you can only combine residential with residential, or commercial with commercial.

You must keep contemporaneous records of the time spent. This is harsher than the passive loss rules, which do not mandate contemporaneous recordkeeping.

Your time records must include hours spent, specific activities, who did the work and the dates of each activity.

Virtually no one keeps such records. Virtually no one with rental houses needs to spend 250 or more hours during a single year on the rentals.

So as Don Gibson sang in 1961, followed by many cover singers, “The lights in the harbor, don’t shine for me. I’m like a lost ship, adrift on the sea. The sea of heartbreak.” This harbor is not safe.

The signs posted in the IRS’ harbor say that just because you leave the harbor does not mean it is not safe. It’s just that if you remain in the harbor, you are safe.

But many can’t see beyond the lights of the harbor. You can easily find “popular press” articles that state the harbor as the law.

IRS agents may also interpret the harbor as setting the law. On audit you may be singing, “I am on this sea of tears, (the) sea of heartbreak.”

What do you do, then, if you must leave the harbor for the open sea? Just rely on what the law, as the U.S. Tax Court interprets it, says.

Almost 80 years ago the predecessor to the Tax Court said that a single rental house, with virtually no activity, was a business.

Mr. Hazard lived in a home in Kansas City. In 1939, he was transferred to Pittsburgh. He listed the Kansas City home for sale or rent. It was rented until a sale in 1943.

Hazard, remember, was in Pittsburgh during the entire rental period. That’s 840 miles. In the early 1940s. No computer. Only a rotary phone. How much “work” could Hazard do?

IRS initially agreed to follow the Hazard decision. In 1981, the Chief Counsel’s Office debated changing that decision.

In the end, it was decided that by 1981 the Tax Court had “too many cases” that agreed with the result of Hazard that it would be fruitless to challenge the result.

Is it safe? Yes, it’s so safe you wouldn’t believe it, according to the Tax Court. No, it’s not safe on the IRS’ “Sea of Heartbreak.”