The Limited Augusta Rule for Self-Rentals – Houston Tax Attorneys

While many taxpayers want to pay less in tax and there are legitimate ways to do so, some of the tax planning concepts that are frequently discussed miss the mark.

The so-called Augusta rule is often one of them. Tax planners often cite this rule and provide tax savings estimates based on unreasonable assumptions. This takes what often amounts to a very negligible tax deduction and makes it into an inexplicably large tax deduction.

This brings us to the Jadhav v. Commissioner, No. 12520-19 (U.S.T.C. Nov. 21, 2023) case. The court in Jadhav addresses a tax plan involving the so-called Augusta rule. The case is similar to others, such as the recent Sinopoli v. Commissioner, T.C. Memo. 2023-105, case.

Facts & Procedural History

The taxpayers in the Jadhav case are a married couple who owned both a sole proprietorship business in the chemical sales industry as well as several residential rental properties.

Seeking tax and business planning advice, they engaged a tax planning firm that suggested converting the sole proprietorship to an S corporation. The firm then recommended renting their personal homes to the S corporation for up to two weeks per year to generate rental expense deductions.

Pursuant to this proposal, from 2014-2017 the taxpayers rented the homes to the S corporation for 14 days annually at rates of either $2,000 or $2,500 per day. The S corporation claimed deductions between $35,000 – $119,000 for rent paid back to themselves as the owners.

On audit by the IRS, the IRS disallowed these rental deductions in full for lacking proof of reasonableness in relation to fair rental value. The taxpayers challenged the IRS determination in the U.S. Tax Court.

Short-Term Self-Rentals

The Augusta rule is found in a court case. And yes, the court case concludes that the tax strategy works. But with that said, it is not even worth addressing the court case. The rules can be found directly in the tax code.

The tax code says that rental income generally has to be picked up as income for purposes of our income tax laws. Rental income usually comes with rental expenses as tax deductions. These are expenses incurred to obtain the rental income. The net rental income is then subject to various limitations that can disallow net losses, etc.

For the party that rents a property, rent is a type of expense that is generally deductible. These expenses can be deductible under the general rule allowing for business deductions under Section 162 of the tax code. This does not apply to personal expenses, generally. The personal use of one’s home is an example of a non-business deduction that is not deductible under Section 162.

As relevant to this article, this is where Section 280A(g) comes in. This is the so-called Augusta rule. Section 280A(g) says that the use of a dwelling unit that is the taxpayer’s residence for less than 15 days during the year, results in no rental income having to be reported for the owner. It also disallows the expenses as deductions by the owner for this short-term rental use. The rule does not address the tax deduction for the party who rents the property.

This can allow business owners to rent out their residences for less than 15 days annually to exclude any rental income received. In exchange, no expenses related to the rental use are deductible during that period either. So renting a home for up to 14 days to a business the taxpayer owns can let them effectively receive payments tax-free while the business claims deductions for rent paid.

Reasonable Daily Rental Rates

This brings us back to the current court case. The tax deductions claimed by the taxpayers were substantial. This was primarily due to the high daily rent numbers the taxpayers used.

The taxpayers were advised by their tax planner to use a reasonable rental rate supported by independent comparables. The tax planner also suggested that the taxpayer retain a professional appraiser to determine fair rental values for their properties.  Despite providing this advice, the tax planner included a chart in their tax report using very high comparables. The taxpayers simply used the numbers from this chart from the tax planner. They did not get independent comparables and did not retain a professional appraiser.

The court concluded that the amount of the tax deductions was not reasonable. It upheld the IRS’s denial of the rent expense. It also rejected the taxpayer’s argument that some amount should be allowed as the rental amount was more than zero. The court noted that the taxpayers had failed to provide evidence of what that reasonable non-zero number might be.

More Typical Tax Savings

Had the taxpayers used independent comparables or an appraiser or had the court hazarded a guess, they would have likely found that the daily rental amount was relatively small.

The court has hazarded a guess in other cases. For example, in the Sinopoli v. Commissioner case cited above, the court found that the daily rate for a property in Lousiana was $500 a day–resulting in a $7,000 tax deduction (times a 35% tax rate, which amounts to a $2,450 tax savings for the year).

For all but the most expensive properties, this is probably closer to the norm. Even if the higher short-term rental rates are comparable to VBRO, etc. are used, the property would still not generate all that large of daily rental rates. This is why Section 280A(g) is often not worth pursuing. The resulting tax deductions are just too small to bother with, particularly given the increased scrutiny the tax deduction is likely to draw. Even the representation for an IRS audit will exceed the amount of the tax savings.

The Takeaway

As in this court case, and others, tax advisors often tout the Augusta Rule using inflated assumptions displaying exaggerated tax savings. When realistic rents are considered, the opportunity for the Augusta rule usually proves nominal. Taxpayers who choose to pursue this strategy should secure objective market support for any projections. This still may not be enough to get the benefit of this tax strategy. The results may still inevitably mirror the taxpayers’ frustrating experience here.