Rental Income - Abandoned Property

Technical topics regarding tax preparation.
#1
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I have a theoretical question based on something something I've been reading...

Taxpayer is in possession of and has been renting vacant and abandoned properties for a few years. When discovered by the taxpayer, the taxes on these properties had not been paid for at least 2.5 years and the owner of the property could not be located with considerable effort. His state of residence allows him to clean up the properties and rent them as they are abandoned.

Rental agreements state the owner of record or the taxpayer may cancel the rental agreement at any time. Rental revenue goes into segregated accounts, the legal owner of which is the taxpayer. Property taxes and maintenance are paid from these accounts. When improvements are necessary, the taxpayer offers the tenants discounted rent to make the improvements. The taxpayer's state has a 6 year statute of limitations to claim past due rent, and because of this he has not taken any money out of the segregated account.

The taxpayer argues that as he is not the legal owner of the property, none of the rental income is taxable to him.

I believe he is the beneficial owner of the property and should be reporting the rental activities. Depreciation taken on only the improvements he or his tenants paid for.

What say you?
 

#2
Chay  
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In this case, state property laws would be the deciding factor, so we'd need to know which state in order for our answer to be conclusive. But if the state in question does allow non-owners to take over properties and rent them out, then I imagine the same state would provide favorable laws with regard to the non-owner's rights in the property and the rent derived from it.

So, I would generally agree with your take on the situation.

Depending on what rights the taxpayer acquires with regard to the underlying property, he may even need to recognize windfall income in an amount equal to the FMV of the property. He would then have basis in the property which could be depreciated.
 

#3
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The state is Washington.

It appears Washington code section 7.28.050 allows a 7 year statute of limitations for owners to bring action against those who adversely possess their property.

https://app.leg.wa.gov/RCW/default.aspx?cite=7.28.050
 

#4
Nilodop  
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Please explain this further. The taxpayer's state has a 6 year statute of limitations to claim past due rent, and because of this he has not taken any money out of the segregated account.. Claim by whom? What past due rent? Does it mean the "lost" owner can come back and take the rent from the segregated accounts (last 6 years')?
 

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Nilodop wrote:Claim by whom?


The legal owner of title can claim money in the segregated account (rents) collected by the taxpayer who possesses the property.

Nilodop wrote:What past due rent?


Wording was bad. Rents collected by the possessor not turned over to the owner of title.

Nilodop wrote:Does it mean the "lost" owner can come back and take the rent from the segregated accounts (last 6 years')?


Yes.
 

#6
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https://www.denomillikan.com/practice-a ... ossession/

Good summary of Washington state law (and I know it's not authoritative). It appears 10 years is needed for adverse possession, but only 7 for good faith color of title.

The adverse possessor must physically use the land as a property owner would. Merely walking or hunting on land does not establish actual possession. The actions of the adverse possessor must change the state of the land. In the case of non-residential property, this could mean clearing, mowing, planting or harvesting produce, logging or cutting timber, mining, fencing, pulling tree stumps, running livestock, constructing buildings, or other like improvements. If the property is residential, this could mean mowing the yard, trimming trees and hedges, changing locks, or repairing or replacing fixtures such as a swimming pool pump, sprinkler system, or appliances.

In order to claim adverse possession, one of the prongs is that the possessor must use the property as a property owner would. It would seem to me this would mean reporting the rental activity on his tax return as that's what a property owner would do...
 

#7
Chay  
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It sounds a lot like the taxpayer needs to prove beneficial ownership for a number of years in order to qualify for legal ownership of the property.

If so, I think we'd start out exactly as you suggested. Then we would need to look at the rights that begin to accrue to the taxpayer, possibly taking those rights into income. Sounds like there might be taxable events in years 7 and 10.
 

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Thanks Chay, agree.
 

#9
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This is interesting. I think the taxpayer's argument that they are not (yet) entitled to the funds in the segregrated account might be a good argument depending on the precise wording of the laws in question. I disagree that he is the beneficial owner of the property if there is a substantial risk of being required to hand over the rent. If the taxpayer is right, then he is holding the funds in trust for an as-yet undetermined beneficiary -- which may turn out to be himself. A Form 1041 should be filed, even though there is no trust document as such. This is what is called a "constructive trust". I think a single 1041, with multiple unknown beneficiaries, for the entire activity should be sufficient. Fortunately, no K-1 needs to be issued if there are no income distributions.

This turns somewhat on what "his state of residence allows him to clean up the properties and rent them as they are abandoned" means. I couldn't find the law stating this. Does the law allow the taxpayer to keep the rents, does it require the taxpayer to keep the rents in trust, or is it silent and the taxpayer is just being cautious?
 

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MSchmahl wrote:Does the law allow the taxpayer to keep the rents, does it require the taxpayer to keep the rents in trust, or is it silent and the taxpayer is just being cautious?


The legal owner of title has a 6 year statute of limitations to claim rents collected by the taxpayer, as previously mentioned.

Taxpayer is not required to hold the rents in a segregated or escrow account. He is just being cautious. If the owner of title "reappears" within 6 years and claims the rents, the owner can be paid with taxpayer's funds from other sources.
 

#11
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If it is supposed to be reported on 1040 Schedule E, I wonder what happens if the true owner shows up and claims the rents. Is this a Schedule E deduction, or a Sec. 1341 deduction/credit?
 

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MSchmahl wrote:If it is supposed to be reported on 1040 Schedule E, I wonder what happens if the true owner shows up and claims the rents. Is this a Schedule E deduction, or a Sec. 1341 deduction/credit?


It's a good question. I was wondering the same thing.

Your idea about a 1041 is interesting and makes sense to me.

I don't think there's a big risk that the owner of title will reappear and claim the collected rents. From what I read the taxpayer has a handful that are about to hit the 6 year mark and not one claim.

The taxpayer's broader assertion was that no one is taxable on the rental activities. Not him, not the owner of title. I took issue with that as it's obviously wrong.

Thanks everyone for the discussion thus far.
 

#13
Nilodop  
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Taxpayer is not required to hold the rents in a segregated or escrow account. He is just being cautious.. That's different than the impression I had from the OP. So he can spend it, invest it, give it away, whatever? That sounds like income to me, subject only to an (apparently) remote chance that he'll be required to return it.
 

#14
Nilodop  
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When improvements are necessary, the taxpayer offers the tenants discounted rent to make the improvements.. There's a rule in 1.61-8(c) that treats this as additional rent.
 

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Nilodop wrote:Taxpayer is not required to hold the rents in a segregated or escrow account. He is just being cautious.. That's different than the impression I had from the OP. So he can spend it, invest it, give it away, whatever? That sounds like income to me, subject only to an (apparently) remote chance that he'll be required to return it.


Agree, especially when taking into consideration the possessor needs to behave as an owner to claim adverse possession and take title after 7 or 10 years. I imagine the court wouldn't look too fondly on the possessor collecting rent for 7 or 10 years and never paying taxes...

If the rents were restricted from use by the possessor, I think we get treatment similar to what was mentioned in post #9.
 


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