In today’s difficult residential real estate market, many homeowners who must relocate have found it difficult to sell their properties. Many have attempted to rent out their prior homes.

A recent Tax Court decision (Hattie M. Bonds v. Commissioner, TC Summary Opinion 2011-122, Oct. 17, 2011) illustrates the challenges one homeowner faced in substantiating her tax position.

Hattie Bonds moved from Kansas City to Minneapolis-St. Paul in 1988. After she relocated, Bonds rented her Kansas City house to various tenants through 2004 or 2005. Since then, the house has not been rented. Bonds attributed her failure to rent the property to a number of factors, including the economy and the property’s location. She never listed the home for sale, but she was told by a realtor that she could sell it at a gain.

In 2006 and 2007, Bonds claimed annual losses of over $12,000, from expenses such as advertising, auto, travel, cleaning, maintenance, insurance, mortgage interest and taxes, and depreciation.

The IRS disallowed the rental losses, taking the position that the Kansas City house was not held for the production of income but was kept by Bonds for personal reasons. The IRS also said the losses resulted from a passive activity and that Bonds’ claimed expenses lacked substantiation. The IRS permitted Bonds to claim her expenses for real estate taxes and mortgage insurance as itemized deductions.

The Tax Court held that the facts established that Bonds converted the Kansas City house from personal use to property held for production of income when she relocated to Minnesota. Even in years when Bonds derived no rental income, the property continued to appreciate in value and the possibility of gain upon sale distinctly existed in 2006 and 2007. The Tax Court said that, on the facts, the home was held for the production of income during 2006 and 2007.

The court also held that, because Bonds participated in a significant and bona fide sense in making management decisions, she satisfied the active participation standard in 2006 and 2007 and was therefore entitled to offset her nonpassive income for those years by her substantiated rental losses, subject to the phaseout limitation.

However, the Tax Court allowed Bonds to claim only $6,499 in house-related expenses for 2006 and $6,435 for 2007 and disallowed the rest because she failed to keep adequate records of her expenses. The court also upheld the IRS imposition of the accuracy-related penalty related to the underpayments attributable to the record-keeping deficiency.