RTS #019 The Augusta Rule struck down by tax court
Depending on where you look, you can see an almost constant refrain from some financial advisors and tax professionals around the Augusta rule: “Don’t do it! It’s a waste of time and not worth it!” These same people probably saw a recent court ruling on the topic and took comfort in assuring themselves they were right all along…but I think the ruling is a major win for people who are using the Augusta rule correctly.
If you haven’t seen the court case yet, the IRS disallowed $280,000+ of tax-free income claimed through the Augusta rule and charged penalties and interest on top of the back taxes on that income. How is that possibly a good thing? Because in this case, the taxpayer was wildly abusing the rule, AND the court laid out exactly what they should have done to properly take advantage of the strategy.
So now we have a recent court case setting the precedent that this is a valid strategy, including a business owner renting their personal home to their business and getting tax-free income on their 1040 while still claiming a deduction on their business return. BUT you have to pay attention to the details and not get carried away. In the situation addressed by the court case, the taxpayer had claimed nearly $300,000 of rental income over the course of just 3 years and had no documentation to support how they determined the fair rental value or that the renting was, in fact, for a legitimate business purpose.
If you’ve ever considered using the Augusta rule or recommending it to a client, the case summary is a great read so you can see firsthand (and be able to share with your tax professional) where the likely pitfalls are. The IRS also has guidance on adopting this strategy, which is worth being familiar with. Yes, there is an administrative burden to getting this strategy started, but with the right system, it becomes easier to execute year over year and can potentially save thousands in taxes in a single year and tens of thousands, if not more, over time.
What can you do about it?
Have a set process. This applies to so many strategies, but the Augusta rule is an important one to make sure you have a system for making sure “i’s” get dotted and “t’s” get crossed. Whether you are employing the strategy yourself or recommending it to a client, there needs to be a clear method for how you are going to determine and document key areas of the strategy, including:
- How much rent will be charged
- How to ensure you don’t surpass the 14 limit
- How to determine what a legitimate business purpose would be and the documentation you need to go along with it (think agendas and meeting minutes; you need clear of evidence of who attended and what was done)
Like all other tax strategies you also need to make sure you have a clear understanding of how the rule works and what could go wrong before you dive into it or recommend it to a client.
Happy Tax Planning!