WHEN IS A RESIDENCE NOT A DWELLING?

By Leonard J. Candela, CPA

In the amazing world of taxes, a U.S. District Court has essentially ruled in Eugene Holmes, 95-1 USTC 50, 101, 868 F. Supp. 42, that a residence is not a dwelling. It did so in the context of IRC Sec. 280A by finding that shares in a cooperative housing corporation do not meet the IRC's definition of a dwelling, and therefore are not subject to the limitations imposed by Sec. 280A. This section generally disallows deductions with respect to a dwelling unit that is used as a residence; exceptions exist for certain items such as interest, taxes, and home office use, among others.

The facts of this case are as follows: Mark Holmes rented an apartment in Brooklyn Heights, N.Y., with the intention of purchasing shares at an "insider" price if the building "went co-op." The building did go co-op, and Mark and his parents formed a partnership in order to secure financing for the purchase of the shares. Mark continued to rent the apartment after the purchase.

During an audit of the Holmeses' 1985 and 1986 tax returns, the IRS disallowed most of the losses generated by the partnership, asserting that the rent charged to Mark was not a fair rent and that the partnership was not engaged in an activity for profit. The Holmeses paid the taxes and penalties, applied for and partly received refunds, and then brought a civil suit seeking the return of the balance not returned by the IRS.

When a jury ruled in favor of the Holmeses, the IRS renewed its motion and presented the Sec. 280A issue. The Court ruled Sec. 280A inapplicable to the shares of a co-op apartment "(b)ased on its language, its legislative history, the limited scope of 26 USC Sec. 216, and the case prior to the enactment of that provision...."

The Court distinguished between the form of ownership cooperative housing represents--corporate shares--and real property. IRC Sec. 280A(f)(1)(A) defines a dwelling unit as "a house, apartment, condominium, mobile home, boat, or similar property," (emphasis added). The Court stated that "(i)t would be illogical to conclude that shares in or of a cooperative corporation, even though they correlate to the use of a particular apartment, were 'similar property' under the above definition." The Court also stated that... "the deductions were not taken for the use of the dwelling unit but for the ownership of the shares."

Substance over Form

The IRS argued that the doctrine of substance over form would treat the Holmeses as owners of the apartment, causing the deductions to be taken with respect to a dwelling unit, and thus subject to IRC Sec. 280A. The IRS offered no authority for this position, and the Court could not find any. Historically, the Court pointed out, the IRS and the courts recognized the distinction between actual ownership of real property opposed to shares in a corporate owner of real property. Indeed, the allowance of deductions for real estate taxes, interest, and depreciation (when applicable) to tenant shareholders was effected discretely. Real property was not redefined to include cooperative apartments. "Instead, Congress extended certain deductions to certain tenant-stockholders while retaining the distinction between owners of stock and owners of real property."

Although this decision is pro-taxpayer, it does not recognize the substance of the transaction nor the spirit of the law. Under IRC Sec. 1034(f), stock held by a tenant-shareholder of a cooperative housing corporation can qualify as a residence. Yet the Court did not see fit to consider it a "dwelling unit" under IRC Sec. 280A.

In arriving at its decision, the Court focused on the distinction between ownership of shares and ownership of real estate. IRC Sec. 280A is primarily concerned with use, not ownership, and the Holmeses' use as a principal residence should have subjected them to IRC Sec. 280A. IRC Sec. 1034 looks beyond the ownership issue to how the property is used. Perhaps the Court should have done likewise in this case.

Why should the form of co-op ownership distinguish the tax treatment? Why should a co-op owner enjoy the same benefits of home ownership (interest, real estate tax, and depreciation deductions under IRC Sec. 216 and gain deferral under IRC Sec. 1034) as other homeowners, without being subjected to the same limitations and restrictions? It is not stock ownership, but usage (potential or actual) that entitles co-op owners to their benefits as real property owners. It is the same usage that should cause a co-op to be considered similar property under IRC Sec. 280A(f)(1)(A) and be deemed a dwelling unit subject to the IRC Sec. 280A limitations.

Nevertheless, this case has presented co-op owners who have limited their deductions under IRC Sec. 280A's vacation home and home office rules with planning and possible refund opportunities. It may even persuade prospective buyers to choose a co-op over other forms of real estate ownership. *

Editor:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editor:
Richard M. Barth, CPA

OCTOBER 1995 / THE CPA JOURNAL