From Landlord to Tax Evader

RENTAL TO MOTHER ENDED UP IN COURT

A rental agreement with the taxpayer’s mother—which was highly unusual in many respects—ended up in tax court. The court not only disallowed the claimed losses but also confirmed that tax evasion had occurred.

A prerequisite for the tax recognition of a lease agreement is that it is not a sham. The latter is the case when the structure and execution of the lease correspond to what is customary between strangers. This requires that the leased property and the amount of rent to be paid be clearly and unambiguously agreed upon and that the lease be carried out in accordance with the agreement.

In the case at hand, the judges did not consider this to be the case for a variety of reasons:

• For instance, no agreement was reached regarding any utility costs to be paid. Such costs were also never demanded from the mother. A tenancy agreement must be denied in any case where the amount of annual utility costs is substantial.
• The son also had unrestricted access to the house at all times. In the case of third parties, the landlord may only enter the rental property without prior permission if there is imminent danger.
• According to witness statements, it could not be confirmed that the mother also stayed overnight in the house. However, it was proven that the son used the house for overnight stays.
• Contrary to the agreement in the lease, no security deposit was paid. Also contrary to the lease, the mother did not perform the garden maintenance work agreed upon in the lease.
• The son furnished the house with new furniture at his own expense.
• A swimming pool with a sauna area built during the lease term was not mentioned or added to the lease agreement.
• The conversion of the originally existing barn into a residential house was carried out very extensively (solely) according to the son’s personal preferences.

Conclusion:

The overall circumstances led to the declared losses not being recognized. The judges further ruled that the son’s tax returns constituted tax evasion. He had reported negative income even though he knew that the lease agreement with his mother would not withstand an arm’s-length test for the reasons stated, and he had also failed to carry it out as agreed in writing on numerous points.