Tax profs who look for interesting items that can be linked to the materials covered in a typical introduction to federal income tax have had a holiday with reality shows. One that garnered significant attention on the TaxProf Listserve is Extreme Makeover: Home Edition. The question, of course, is how the recipients of the extreme makeover are taxed. Does the network producing the show gross up their award with sufficient tax to pay the income tax due on the award? What about the property tax that will be due on the greatlly enhanced value of the property? If homeowners were already unable to improve their home, can they afford the increased property taxes after the show does it for them?
We learned last year that the producers tell the recipients that the home improvements are non-taxable because they come within an exception allowing homeowners to rent their homes for no more than 14 days during the year without including the rental income in their income subject to federal income tax. Apparently, the producers have told recipients that they are renting their homes for $50,000 and that the improvements to their homes are the rental payment that the show pays for filming in their homes for the two weeks during the time the improvements are being done. See this description. Of course, the problem is that the improvements are usually worth far more than $50,000 and the fair market rental value of the homes to which the wrecking balls are applied is far less than $50,000. This Newsweek story describing the case of a soldier in Iraq who received a home makeover worth $250,000 provides a fuller explanation--that the rental payment is treated as made in-kind with TVs and other appliances, and then the rest of the improvements are considered "leasehold improvements" that revert to the owner without taxation when the tenant (the television production) leaves.
Does that strategy succeed? It was discussed extensively on the TaxProf blog and listserve and on several other blogs over the last couple of years. See, e.g., here (Paul Caron's May 2004 blog), here (Paul Caron's July 2004 follow-up),and here (TaxGuru suggesting that it is gambling income from a lottery of homeowners who apply for the show).
The difficulty with the gameshow's rationale is (at least) twofold: (i) the rental value of the home may not be $50,000 and (ii) the improvements are clearly being offered as a prize or award in a gameshow, and such prizes are included in income unless excluded under a particular provision.
Is the rental value of the not-so-good home what it could be rented for to other tenants? It seems that the fair value would have to be determined by the price that could be commanded in the market, which would be closer to $1000 than to $50,000. But even dumps can be rented by TV crews for special filming and probably command a high price. Can the special nature of the event--a television show's need of a run-down home in need of repairs--merit the higher rental payment? If so, in-kind payment is no different from cash payment. The means of payment shouldn't affect the excludability under 280A(g).
Can the exclusion for leasehold improvements be applied in this setting? The rental agreement and leasehold improvement characterization appear to paper over a situation that would ordinarily be taxable (winning a prize) by creating a sham transaction (leasing a house and, oh what a surprise, receiving leasehold improvements from the tenant). Under this view of the transaction as a sham, the producers are not really renting the house. The family has gleefully accepted a prize --the house makeover--and it just happens that the only way for the producers to give them the prize is to let the construction crews on site. If that is the case--i.e., it's just a prize--then it appears that both the rental and the leasehold improvement justifications for no taxes fail. The improvements are a prize and subject to tax. None of the amount is excluded under 280A(g).
If on the other hand the rental agreement is treated as a bona fide contractual arrangement for the location of a "shoot," then it appears that the treatment of the improvements as tax-free leasehold improvements would follow. It chafes, because we know that the de minimis provision for exclusion of rentals was not thought to cover those types of situations, but then who would have thought that they would cover $75,000 a week rentals during special events either (see below). If there is a lease, how could the IRS treat these improvements as different from any other leasehold improvements? Surely the intent of the leaseholder to benefit the family would not take the improvements out of the general treatment of such improvements for tax purposes. The TV show as leaseholder is in fact building something for its use during the term of the lease. The house is the set, and the changes to the house are the changes to the set during the filming of the production.
So what has the government said? The IRS recently released an information letter on this issue that one can read without knowing for sure whether the IRS has answered the question. In the letter, the IRS notes (i) section 61 requires income to be included, (ii) section 74 specifically provides that prizes and awards are included in gross income and that prizes and awards include amounts received from television giveaway shows and (iii) section 280A(g) excludes from income amounts received for renting a home if the home is rented less than 15 days during a taxable year. (The letter does not mention the exclusion of the value of leasehold improvements from the lessor's income upon reversion of the lease to the lessor.) Then the IRS says that "to the extent" the improvements are prizes they cannot also be considered rent. In spite of the use of the phrase "to the extent", that language suggests a categorical distinction between prizes and rent, and a conclusion that no part of the value of the improvements could be considered rent paid by the producers for the privilege of filming their show in the recipients' home, since the improvements would be categorized as a giveaway prize. Even if that is the right interpretation of this information letter, is it likely that the IRS will try to collect from the recipients?
Now, note that all those wealthy landowners in the Hamptons who rent out their homes for two weeks in the summertime when they are at their own vacation homes elsewhere do get this sweet tax deal without any degree of uncertainty. A week's summer rental income in the Hamptons, a house in New Orleans during Mardi Gras, a house near the Super Bowl, or a house for the Masters Tournament can be $10,000 or $20,000 or more. See this link and this link . There are even reports of a week's rental at $75,000. See this link. That's tax-free income under the afore-mentioned provision in section 280A(g) for the owner of the home. Does that make sense? Clearly no. This is not a de minimis amount of income, and it generally benefits those in the highest income brackets. Poor people and middle income people don't own luxury homes that can be rented out at top dollar for short periods of time (except, of course, those who 'rent' to the producers of Extreme Makeover).
Since there's no fairness justification for the tax break, is there another rationale? Congress could have thought that the tax on rental income from two-week rentals would be so small that it would not be worth the recordkeeping burden on taxpayers while being administratively difficult to enforce for the IRS. But rental rates in the tens of thousands of dollars undercut that argument. So does that fact that rentals of just a few more days must be reported in the return. If we can trust taxpayers to self-report three weeks of rentals, we should be able to trust them to self-report two-week rentals. Even if the total cost to the fisc is small because of the relatively small number of people in position to rent their homes in this way, the fairness rationale for taxing that income clearly outweighs any administrative convenience for the taxpayer or for the IRS in not taking it into account.
Congress has considered eliminating the de minimis rental exclusion several times. George H.W. Bush vetoed a repeal provision, and Bill Clinton proposed one. A February 15, 2005 Congressional Research Service study, linked here, reports on the history of the provision and efforts to repeal or moderate it, including a proposal put forward by the Joint Committee on Taxation for a $2000 cap to the income that can be excluded. Capping the break would be better than permitting the wealthy to enjoy the windfall exclusion they now have, but eliminating the break altogether makes the most sense.