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Tuesday, June 02, 2009No deduction for costs before real estate business actually began; training classes nondeductible
Thomas J. Woody, TC Memo 2009-93
Thinking about starting a business in real estate? Dot your 'i's and cross your "t's ! A recent Tax Court decision deals with a taxpayer who spent big money to get into the real estate business but wasn't entitled to deduct his expenses for a couple of reasons 1) because they were incurred before his business began and 2) because they were incurred for a new career as such deemed nondeductible educational expenses.
Background. To be deductible under Internal Revenue Code (IRC) 162, ordinary and necessary business expenses must be directly connected with or pertain to the taxpayer's trade or business. The entity must be functioning as a business when the expenses are incurred. Until the business is functioning as a going concern, expenses related to it are not ordinary and necessary expenses but, rather, startup expenses that may be deductible over a period of time under IRC 195 .
Facts. In 2004, Thomas J. Woody started investigating the real estate market so that he could buy properties for investment or rental purposes. He created a name for his venture (Value Property Investments) and began marketing his services via business cards, flyers, and word of mouth. In May 2004, Mr. Woody completed a business outline for his venture with “buying, remodeling, and renting property” being its stated purpose. On Oct. 17, 2004, Woody paid $21,490 to the Wealth Intelligence Academy for certain training classes, which he subsequently attended to acquire real estate investment skills. After taking the courses, his business plan shifted from merely buying, remodeling, and renting to also include what Woody referred to as “flipping” or “wholesaling.” However, he never completed this type of transaction during 2004. In November of 2004, he got a loan from the U.S. Small Business Administration and got an employer identification number from IRS. In December of 2004, he got a credit card in the name of “Thomas J. Woody Value Property Invest” and opened a checking account in the name of “Mr. Thomas J. Woody D/B/A Value Property Investments.”
Despite his efforts, Woody didn't actually engage in any real estate activity until Dec. 30, 2004, when he bought an investment property. He didn't succeed in renting it out until 2005.
On his 2004 tax return Woody reported $23,373 of expenses on Schedule C, consisting of the cost of his training classes (the majority of $21,515) and expenses for car expenses, supplies, meals and entertainment, and computer and software costs.
IRS disallowed Woody's claimed Schedule C deductions on the ground that he wasn't engaged in the active conduct of a trade or business and determined an income tax deficiency of $4,955. Woody appealed to the Tax Court.
No business deductions until business actually commences. The Tax Court pointed out that in determining whether a trade or business exists, the courts have examined: (1) whether the taxpayer undertook the activity intending to earn a profit; (2) whether the taxpayer was regularly and actively involved in the activity; and (3) whether the taxpayer's activity actually commenced. The Tax Court found the third factor to be determinative in Woody's case. Until he actually began to buy, remodel, or rent— i.e., to perform the activities for which he organized Value Property Investments—he was not carrying on a trade or business for IRC 162 purposes. And until that time, none of his expenses could be claimed as IRC 162 expenses. The Tax Court found that Woody's activities did not rise to the level of a trade or business until, at the earliest, the time he purchased investment property on Dec. 30, 2004, and more likely, did not rise to that level until he held the property out for rent sometime after the close of 2004. If the earliest possible date he was actively carrying on a trade or business was Dec. 30, 2004, then any expenses incurred in that year but incurred before the active trade or business began would be, by definition start-up expenses rather than ordinary and necessary business expenses.
The Tax Court pointed out that Woody's largest expenditure in 2004—$21,515 for workshops and training—was an educational expense incurred to prepare for a new career, i.e., real estate investor and renter, rather than to maintain or improve skills in an ongoing business or career. It was therefore not deductible under IRC 162 nor would of been if classified as a start up expense.
Note: The treatment of start-up costs were different in 2004 where there had to be an election filed with the taxpayers return. The regulations changed in October of 2004 eliminating this election however, only a very small portion of Woody's expenses were incurred after that date and wouldn't have helped him much. Even if Woody had paid for his educational expenses after Oct. 22, 2004, he couldn't have amortized the cost as start-up under IRC 195. A start-up expense must be one that, if paid or incurred in connection with the operation of an existing active trade or business (in the same field as the taxpayer's new business), would be deductible for the year in which paid or incurred. Because the educational expenses would not have been deductible under ordinary and necessary, they could not have been amortized as start-expenses.
Greg Nelson CPA, MBT
Olsen Thielen, CPAs
