Individuals with real estate businesses often expect to deduct business-related expenses for tax purposes. But those tax deductions might not be a guarantee. One married taxpayer recently learned the hard way when the IRS disputed business deductions that led them to the U.S. Tax Court.

Sarkin v. Commissioner provides a helpful overview of how the IRS and the Tax Court review and determine if expenses qualify as deductible business-related costs — specifically, the factors that they consider when assessing whether a business activity was engaged in for profit.

Contested tax deductions

The taxpayers opened a foreign urban planning company in 1997. By 2004, they relocated to the United States and found new employment for five years. But after having been unemployed for two years, the husband returned to his original plan and decided to convert his foreign apartment into an office, using his time there to renovate his family home. The taxpayers claimed $24,749 and $14,132 in expenses for a real estate consulting business on their 2012 and 2013 federal tax returns. The IRS challenged and rejected the deductions, claiming that they were not entitled to deductions unless they were engaged in a trade or business for profit.

The taxpayers appealed the IRS ruling based on a nonexclusive list of factors to consider when evaluating a business for a profit objective.

The following seven factors were evaluated by the IRS:

1. The manner in which the activity is conducted.
   The taxpayers did not have a written business plan. Moreover, the business did not open a separate bank account; all expenses were paid from the personal checking account and credit cards.
2. The time and effort devoted to the activity.
   The husband did not spend all of the two years in the foreign residence and the court inferred that he did not focus much time on the business.
3. The expectation of asset appreciation.
   The taxpayers did not have an expectation that assets used in the business activity would produce an overall economic profit or create a profit motive. The taxpayers only had a single asset which was the previously used apartment.
4. The taxpayers had success in similar or dissimilar activities.
   Without any evidence of earlier results from the business, the court did not know whether success had ever occurred.  The renovation project was not similar to the previous work started in the same country.
5. History of income and loss.
   Although a series of losses in the initial startup of an activity does not prove a lack of profit motive, the goal must be to realize a profit on the entire operation. The taxpayers reported net losses for the current years and abandoned the business the next year.
6. The amount of occasional profits.
   The business was always reporting annual tax losses since the beginning of the activity and was never able to report or earn a profit.
7. The taxpayers’ overall financial status.
   A lack of substantial income from other sources can either help or hurt the business purpose of the activity. The husband was unemployed before the years at issue, but the wife had significant income from working as an architect. Since business losses generated large tax benefits for the couple, they were unclear about their commitment.

Experience and advice can help

The court rated one additional factor as neutral — the expertise of the taxpayers or their advisors. The husband had the relevant work experience and adequate education to conduct a city planning and architecture business.  But without a business plan or advice from outside consultants, the court did not find any evidence to corroborate his previous efforts or current experience in the renovation of personal residences.  The court accepted the husband’s testimony that he derived no personal pleasure from conducting the business, so there were limited facts to help his story.

Tax law does not allow hobby losses

With the business factors going against the taxpayers, the court concluded no “actual, honest profit objective” existed. The business deductions claimed for both years were disallowed.  The IRS created hobby loss rules that if profit is rare, you have a personal hobby, but if you regularly earn a profit, you have a business. Specifically, if you turn a profit in three of the last five years, you probably have a business.  Once you have losses for three consecutive tax years, the IRS assumes that you would reconsider whether the expectation in the business is very realistic.

Manage your business expectation

If you are looking to deduct business-related expenses, be sure you are able to support your claims that the activity has an actual, defendable profit motive. 

If you have any tax questions about the profit motive for your business, please contact Tom Kosinski at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.