Unusual Tax Question Is this money for nothing? Is it Tax Free?

126 Replies

I intend to borrow money from segregated rental income accounts that I have established for multiple parcels of apparently abandoned real estate that I control, but do not own. Does anyone know, of a law (State or Federal) that requires me to report, pay taxes on, or limit how long I may borrow these funds?

For a number of years, I've been in possession of and have been renting multiple vacant and apparently abandoned parcels of real property, both improved and unimproved. These properties where identified from their County's list of parcels that are delinquent in paying their property taxes. (WA is a tax deed state in which counties file Property Tax Foreclosure actions after a property is 3 years delinquent). Each property was vacant and unmaintained, no one had paid the property taxes for at least 2.5 years, and the owner of record either could not be located with considerable effort or was found to be deceased. Upon compiling abundant evidence that the owners appeared to have abandoned these properties, I caused the properties to be cleaned up, rented them, and have since managed them almost as though they were my own.

Despite being in possession, I have no ownership interest in any of the properties. (Under the trespass law in my State (WA), an owner's abandonment of real estate is a recognized defense to a charge of Trespass) https://app.leg.wa.gov/RCW/default.aspx?cite=9A.52.090. All rental agreements that I’ve made with the tenants of these apparently abandoned properties are month to month, and state clearly who the owner of record is, that the owner is currently absent for an unspecified length of time, and that the rental agreement may be terminated by me or the owner, if the owner returns.

Up to this point, the rents paid by tenants on these properties have gone into segregated accounts (not mixed with my own money). Where improvements were necessary in order to create a legally rentable space, tenants were offered discounted rent in exchange for making the necessary improvements. The tenants provided all needed labor, and the required materials were purchased slowly from the discounted rent paid by the tenant. Once a property was made minimally livable, any rents collected were deposited into the segregated accounts. After a property is livable (fully enclosed, power available, safe water, heated, etc.) all rents collected have been used only as necessary for property maintenance and to pay property taxes.

This has been a long process, the rents are generally low and the segregated accounts grow slowly, but growth is accelerating and now the total in all the segregated rental income accounts that I've set up is approaching mid five figures. Over the last five years no one has appeared to contest my possession of a property. They appear to be truly abandoned (WA law requires 10 years to adverse possess without color of title https://app.leg.wa.gov/rcw/default.aspx?cite=4.16.020). Since, WA law also has a six year statute of limitations to claim past due rent https://app.leg.wa.gov/RCW/default.aspx?cite=4.16.040 , I expect to soon have increased flexibility to use the money in the segregated rental income accounts that I’ve set up and control. For example, I could invest the funds in a loan to myself.

Does anyone know whether I am required to report a loan to anyone if I borrow money from one or more of these segregated accounts? And, if I never attempt to gain title to these properties (so that the properties and rents are never officially recognized as mine), does the money that I borrow ever become income to me -even when no one is likely to ever require me to pay it back? Do I need to ever pay Federal Income taxes on the money I spend from such a loan?

The funds you are receiving as rental income is taxable and should be reported to the IRS annually on your tax return (or the entity you are using to collect the rent under). Assuming 10 years goes by and you are able to eventually gain ownership of the properties, you would pay capital gains tax if/when you sold them.

@Steven M. At this point, I have not "received" any funds.   What I have done is collected somebody else's rents and temporarily stored those funds that belong to the owner's of the real estate in accounts that I control.  Since, I am not the owner of record on any of these parcels, the rent's that I have collected are not mine to spend.  In the event that any or all of the owner's (or their heirs) appear and request the rents that I've collected, a court will compel me to disgorge the rents to the legal owner.  That is why the rents are kept in accounts that are segregated (separate) from my own finances.

It is true that I have good reason to believe that the owner's have abandoned their property, but my belief does not establish the alleged abandonment of their real estate as a matter of law.  Acquiring ownership of the rents or of the real estate requires waiting 10 years from my first possession of the property, then filing a lawsuit and receiving a judgement in my favor.

Six years or more, after collecting these rents, I will seek to invest the rents by loaning them to a company that I own.   The loan will pay a reasonable interest rate into the segregated account being held for the owner of the property.   The question becomes at what point, if ever,  would the law require me to report the loan, or pay taxes on the rents borrowed, or limit my ability to borrow these rents that belong to the owners of the real property?  

The answer that you and I agree completely on is that should I eventually gain ownership of these properties, I would then be required to pay tax on the net income from all the rents I've collected (including the interest income those rents earned), and if I later sold the real estate, at that point I would be required to pay tax on the gain.  

However, what if I never seek to gain ownership of the real estate?   I know of no law that compels me to do so.  If I never seek ownership of these properties, I believe the rents that my company borrowers would remain loans, which are not taxed?  Is there a law which specifies that I'd owe taxes on rents which the law does not recognize as mine?

@Eamonn McElroy , All of the segregated rental income accounts related to this post are under my own name at a local bank or Credit Union. I am the legal owner of the accounts. I have momentary control of those funds. However, that does not mean that the money in those accounts is mine to do with as I please. It is a matter of public record that each property is owned by other persons (or their heirs). As a matter of WA law, the real estate and the rents collected (by me) from those parcels, remain the property of the owner of the real estate. That is why the rents I've collected from the properties that I do not own, are kept separate from my finances. At this point, WA law views me similar to a property manager (who is unauthorized by the owner(s) to do anything).

After 6 years, I could claim the WA Statute of Limitations as a valid defense against an owner or heir who showed up to reclaim their RE or who sought to be reimbursed the rents that I've collected. However, the Statute of Limitations is only a defense against being compelled to disgorge the rents that I've collected. The six-year Statute of Limitations does not give me any ownership right in those rents because the rents belong to the owner of the property. Nor does the 10-year Statute of Limitations give me any ownership interest in the real estate itself. Gaining legal right to either the rents, or the real estate requires a separate action. The Statute merely announces that after 6 years the courts will no longer enforce the property owner's right to those rents, and after 10 years I may make a claim to the property if I file a suit for it.

My thinking is that since I already control the rents and owe no taxes on those rents because they as a matter of law neither the property nor the rents are recognized as mine, I should therefore never claim legal ownership of the rent's that I’m collecting from these properties. Instead, I should acknowledge these rents belong to the unwitting owner or heirs, and I should invest their money by loaning it out at a reasonable interest rate to a company I control. If, as I suspect, no heirs ever show up to collect the rents due on their property, then I can repeatedly renew the loans each time they become due, until eventually my own heirs will be entitled to deal with the properties and the rents as they see fit.

@Davido Davido

"My thinking is that since I already control the rents and owe no taxes on those rents"

It seems a little odd to me that no one is taxed on this rental income.  Doesn't that seem a little odd to you?  Not you, not the "unwitting" owner (if living), not the estate of the owner (if deceased).

Are you preparing and issuing 1099-MISCs for rent collected to the property owner or estate of the owner?  As you said you're more like a property manager than anything else.  Seems to me you have an obligation at the federal level no matter what WA state law says.

If the money is legally yours you cannot borrow money from yourself.  The interest payments back and forth won't be respected for tax purposes.

If the money is legally someone elses, then that person should be including the interest income on their tax return, and you maybe be able to deduct the interest depending on what the money is used for.

@Eamonn McElroy , Thank you for your input.  

Yes, what is happening here is certainly odd.  The owner of the rents is unaware of them, has not yet received them, and therefore he/she is paying no taxes on the rents.  The rents are not mine, so I have neither spent them, nor paid taxes on them.  Thus the situation is odd (rare) to you, and to me, and to most everyone.  It is unusual for an owner to apparently abandon valuable real estate -but it happens several times per year in my county.  It is also unusual for a person, like me, to assume possession of such an abandoned property and manage it, but that too happens in my county and in others around the country.  Despite happening with only perhaps one parcel out of 40,000, these situations are quite real.  When they happen, the question becomes what does the law permit and what does the law require in regard to reporting the rents that I collect for the absent owner?   Who is responsible for the paying taxes on those rents (if anyone)?   And what is permitted and required regarding my intent to borrow the rents collected.  

I agree with you that the IRS won't respect interest deductions based on borrowing money from myself.   At this point, the rents I've collected are clearly not mine.  The question I have is; -at what point would the IRS declare the apparently abandoned rents to be mine?  Though the situation is odd (rare), it is what I face, and I seek to understand the relevant laws. 

No I have never prepared or issued IRS form 1099 MISC to an owner, to their estate, or to the heirs of the property. It could be that a 1099 MISC is required, but I do not think so. Up to this date, I have not paid the owners of these properties a penny. A 1099 would be applicable if and when I actually pay the rent's I've collected to an owner. So far in each case the owner can not be found, notarized mail addressed to the owners address on file with the county treasurer is returned as undeliverable, and each owner's heirs (if any) have not opened probate. Since, I have not paid any money (rents or other income) to the owner, a 1099 MISC is not required. The money that the owner is entitled to sits in a custodial account (my account -held for them).
 
Yes, we also agree, "it seems (I should) have an obligation" to both the state and federal governments regarding the rents I've collected. The question is, in what law (if any) is that obligation spelled out?

It is clear to me that the rents I've collected by managing real estate which belongs to another person are not legally mine.  It is also clear that after 10 years I can, if desired, obtain title to to these properties (in WA) and obtaining title would make the rents I've collected legally mine as well.  I would then owe tax on the rental income.  But it appears to me, that I have no tax liability if I leave these properties in the present owner's name and instead borrow their rents, which I have become the custodian and manager of.  So I'm wondering, what law (if any) prevents that course of action.

Who are these tenants writing the check to?

Who's name is on the lease?

IRS looks at circumstance tests too and if you're renting property you're controlling that's your income to report. You didn't find some magic loophole that you're renting abandoned land to try to gain ownership of it and in the mean time collecting rents tax free. 

To claim ownership on adverse possession in WA you need to pay the taxes and basically treat the property like your own- if you're also renting it you should be reporting those rents.

You can get opinions from us on BP all day long but I bet that the IRS will find a way to say it is taxable income to YOU regardless of how you tell the story.  If the rents are as small and slow growing as you say I just can't imagine it's worth all these semantics to move around the edges of the tax code.

@Davido Davido

"The owner of the rents is unaware of them, has not yet received them"

I'm not surprised.  It appears based on what you've laid out that you're highly incentivized to have no contact with the owner and make sure he/she/the estate isn't aware you're renting the property beyond what is required of you by WA law...

"Since, I have not paid any money (rents or other income) to the owner, a 1099 MISC is not required."

There's a tax doctrine called "constructive receipt" for cash basis taxpayers.  One doesn't have to actually remit the cash in these situations.  Not saying you have a 1099-MISC obligation as I'm not diving into the details, but your assertion isn't valid.

This could go a few different ways. And I think you need to engage a professional who can have the deep conversation with you to understand your facts, circumstances, and the law in WA regarding what you're doing.

I think there's a strong argument to be made that you have beneficial ownership of the property and thus must report the activity.

One thing I do know is no one reporting the activity -- not you, not the owner -- is not correct.

One way or another there is no such thing as tax free income.  While BP is a great resource, this is a highly unusual situation and my only recommendation would be to fork over a few bucks and actually talk to local real estate lawyer and CPA.

@Natalie Kolodij ,  Thank you Natalie your input is appreciated.  The month to month "Rental Agreement" in these cases are written between the renter and I.  All payments come to me, because the owners can not be found.  I assert in each rental agreement who the actual property owner is (based on the deed recorded with our County), that the owner is temporarily absent due to unexplained circumstances, and that I am managing the property and collecting the monthly rent until the owner returns, at which time, either the owner or I can cancel the month to month tenancy.

Thank you particularly for reminding me that the "IRS looks at circumstance tests".  Since the circumstances here are rare I believe the entirety of the overall circumstances would indeed be the test used to decide who's rents I'm holding and who must pay taxes on those rents, if my actions in this regard are ever litigated in tax court.

In regard to the properties involved in this post I manage each property almost as though it were my own (except I do minimal improvements because improvements are not reimbursable if an owner reclaims his/her property). I also collect and deposit the rents into accounts that I control, but each account is segregated from my personal funds and annual attempts are made to contact the owners at their address of record to inform them of my actions. Still, at this point, is that the totality of the circumstances test will weigh more heavily toward the rents being the property and the tax responsibility of the owner of record on the deed. That is true because WA law is clear that absent owner's can return at any time up to the statute of limitations (10 years) evict a squatter/possessor and demand disgorgement of all rents collected. Which is very strong evidence that the legal owner of the rents collected is the legal owner of the property.

The bigger question, for me, is at which point will the totality of the circumstances shift toward the IRS concluding that for tax purposes the property and rents are both mine.  The State and County won't recognize me as owner of either until a judge rules that I'm the legal owner of a given parcel.  It would be simple if the IRS followed the same reasoning.   However, it is possible that at some point after I qualify for adverse possession, the IRS could claim that on the totality of circumstances, leaving the property in the name of someone who has not possessed it, or been found to receive their rent for over ten years, is merely a ploy to avoid liability for the taxes.  

I'm convinced and prepared to argue, if challenged by the IRS, that at least until the law permits me to acquire ownership through adverse possession, the totality of the circumstances establish that I do not own this property and am not responsible to pay income tax on rents that I collect and segregate for the owners. 

This is just one persons opinion.  

You collected rent and you are legally free to spend it how you want to, you have chosen the safest approach for the situation, where you have placed it in separate accounts.  Are you legally required to do this?  Or are you just legally required to pay back the true owner if they come a knocking within the window of time?

Seems to me that you have collected rent and as such would be required to pay taxes on it. Now the whole depreciation issue is a tricky one since it isn't your property to depreciate.

     Think of it another way.  You have a W2 job and you get paid.  They take taxes out.  If you were to stick 50% of your pay into a savings account you don’t expect to not have to pay taxes on that would you???  Seems like you need a tax professional. Like ASAP 

Yeah dude, you need to hire a CPA, ammend your past taxes and pay your past taxes, interest and penalties. You are going to wind up in a very bad position when the IRS comes after you. Youve got a losing argument if you end up in the tax court. You might be talking prosecution for tax avoidance. Get this straightened out sooner rather than later.

Originally posted by @Matt M. :

@Davido Davido

How did you even come into possession of these “abandoned” properties and how did you get permission to rent them out?

 WA has adverse possession laws. 

If a property is abandoned- you can basically squat in it, act like it's yours, and potentially file for ownership in 7 years if you've been maintaining it and paying taxes and such.

Making something on an asset you don't own doesn't mean you're not running a business. You're still regularly participating in an activity with the intent of profit- that's the definition of IRC 162 for a business. 

You're running a business. That's 100% taxable income. 

Originally posted by @Eamonn McElroy :

@Davido Davido

"My thinking is that since I already control the rents and owe no taxes on those rents"

It seems a little odd to me that no one is taxed on this rental income.  Doesn't that seem a little odd to you?  Not you, not the "unwitting" owner (if living), not the estate of the owner (if deceased).

Are you preparing and issuing 1099-MISCs for rent collected to the property owner or estate of the owner?  As you said you're more like a property manager than anything else.  Seems to me you have an obligation at the federal level no matter what WA state law says.

If the money is legally yours you cannot borrow money from yourself.  The interest payments back and forth won't be respected for tax purposes.

If the money is legally someone elses, then that person should be including the interest income on their tax return, and you maybe be able to deduct the interest depending on what the money is used for.

WEll for sure if your going to take the position that your not the owner and simply collecting rent for the true owners of record then you need to have a WA state brokers license with a PM endorsement to collect rent without it is totally illegal

 

Originally posted by @Natalie Kolodij :
Originally posted by @Matt M.:

@Davido Davido

How did you even come into possession of these “abandoned” properties and how did you get permission to rent them out?

 WA has adverse possession laws. 

If a property is abandoned- you can basically squat in it, act like it's yours, and potentially file for ownership in 7 years if you've been maintaining it and paying taxes and such.

winning adverse possession  cases is one of the toughest things to do in real estate .. we know what the laws say.. but end of the day you need a judge to sign off and they are reluctant to give title to someone's property to another.   My brother is working on one in CA that is next to his property so it makes sense.. he adds 5 acres to his 5 acres.. its been a number of years now.. will see how it all comes out.. at the end of the day he uses it like he owns it.. he pays the tax's and he has a court case on going.   

 

Originally posted by @Account Closed :

This is just one persons opinion.  

You collected rent and you are legally free to spend it how you want to, you have chosen the safest approach for the situation, where you have placed it in separate accounts.  Are you legally required to do this?  Or are you just legally required to pay back the true owner if they come a knocking within the window of time?

Seems to me that you have collected rent and as such would be required to pay taxes on it. Now the whole depreciation issue is a tricky one since it isn't your property to depreciate.

     Think of it another way.  You have a W2 job and you get paid.  They take taxes out.  If you were to stick 50% of your pay into a savings account you don’t expect to not have to pay taxes on that would you???  Seems like you need a tax professional. Like ASAP 

if I was betting I would bet that most of these parcels if not all are bare land.. its very rare for an improved property on the west coast to get all the way to tax sale or be totally abandoned..  this is not Detroit or other rust belt cities with literally thousands of abandoned structures.

 

Surely you don't plan to take a random forum member's opinion as legal advice, even if they say what you want to hear. So you're going to ask an attorney and CPA regardless. Why haven't you done so already?

My best advice here is to get a damn GOOD CPA and lawyer and figure out the correct way to do this, and you should do this NOW.

Not a CPA or attorney here, but I see a logical fallacy in your discussion.

Your assertion is that the rents have a potential for being claimed up to 5 years, and as such they belong to the owner so you do not owe taxes on them. You've crossed two separate 'realms' of the rules/guidelines. WA state says that the prior owner can make claim to the funds for up to 5 years. The IRS says that any income needs to be taxed (paraphrasing). While those two items may both be true and both be rules you must follow, WA rules that the owner can make claim to the funds doesn't allow you to somehow 'decide' whether you should be taxed or not. It is like a master lease, you don't own the property but you do receive income from it and therefor pay taxes on that income. The fact that there is a rule whereby someone could claim those funds doesn't eliminate your obligation to pay taxes on the funds you 'earned'....you could reduce your earnings in the event an owner made claim because at that point you would expense the money you provided to them. 

My guess (and it is just that a guess) would be that were you to do your taxes including this income and make repairs ect, and then an owner claimed funds after 4 years. You would have the opportunity to make an accounting for the rents received and how they were applied. That would lower what was owed from the full rent received, to only what was 'leftover'. That would mean that you did in fact pay taxes for funds you ended up having to give back, but that is likely just the cost of taking on this risk for the potential reward of claiming abandoned property. 

Overall this is a very interesting situation and I love it as a creative method in RE! But get the tax situation squared away...because currently I'd suspect that you created a bad situation for yourself as far as the IRS goes.

Thank you to all who have responded to this posting. Your replies have certainly been helpful, though not yet determinative.

I particularly appreciate @Natalie Kolodij ‘s reminder that the IRS is likely to use a totality of the circumstances test, and also appreciate @Eamonn McElroy ‘s reminder that the tax doctrine of “Constructive Receipt” might be applied. For reasons cited in my individual responses to them, I am convinced that applying a test based on the “totality of the circumstances” as to who bears tax liability for the rents I’ve collected, will establish that the rents belong to the individual owners of these apparently abandoned properties. Further, it seems clear to me that, the tax doctrine of “Constructive Receipt” cannot apply to me in regard to the rents I’ve collected because I have only temporary control over the rents. As a matter of WA law, a previously absent property owner who returns to find their property rented out, can evict the tenant I’ve placed in their property and can demand all the rents accrued during my possession. “Constructive Receipt” also does not apply to the absent property owners because they have not received the rents collected from their property, nor do the owners know about or have reason to know about the rents collected, because none of the owners have authorized me to rent out their property.

@John P , I appreciate your cautionary words. You have identified a real problem in your comment, “I bet that the IRS will find a way to say it is taxable income to YOU regardless of how you tell the story.” It is a potentially significant problem for me that judges too frequently allow their basic gut feelings to play a deciding role in how they rule. However, the fact that my situation is odd, unusual or just seems wrong at a gut level does not affect what the law actually requires. Despite the fact that the idea, “Someone has to pay tax on these rents” is the basic instinct of most observers regarding the rents that I have accumulated, as a matter of law that sentiment is only applicable if there is a law, regulation, or court case that establishes my tax liability. The controlling law or case must be cited. Even the IRS does not prosecute individuals based only on what it thinks should be the law, they are required to cite an actual law, regulation or previous decision. My bet is that the IRS cannot say the rents I’ve collected are taxable income to me, -even if they want to. It will be at least ten years before these unspent rents can be considered my income. WA law is clear that rents collected on property owned by another person must be disgorged (paid back) to that owner -upon request. They are not my rents. The question is, can I borrow them?

Though I appreciate all your input, what is most needed is a controlling statute, regulation, court case or tax decisions regarding who, if anyone, must pay income tax on rents collected from apparently abandoned real property, and what, if any, are the tax consequences to me, as current manager of these properties, if I borrow those rents.

The basic advice I'm receiving in this post is that what I'm doing appears dangerous, and specific Tax questions should be answered by a CPA, and legal questions should be presented to an Attorney. Eventually, after educating myself as much as reasonable, I will consult those paid professionals. In the meantime, we have multiple CPA's and Attorneys here on Bigger Pockets. If the issues were clear or routine one of them would have been likely to reference a controlling statute or decision. I suspect no one has cited a controlling law because similar matters have seldom or never been previously litigated. For that reason, even paid professionals are likely to offer limited authority on the issues.

For anyone reading this, is interested in the subject matter, I will repost the substance of my questions in a different format and provide a link below. My situation is very similar to that of a property manager who encounters a situation where the owner of a property suddenly disappears and leaves the property manager without an account or address at which to deposit the rents. In that case, what are the property manager’s responsibilities? When, if ever, do the rents he collects monthly belong to the property manager. Can the property manager borrow those rents? Perhaps phrasing the issue that way will result in reference to a controlling law.