The Importance of Profit Motive: U.S. Tax Court Rules Renovation Activities Weren’t a Business
Individuals with real estate businesses understandably expect to deduct their business-related expenses. But those deductions might not be a slam dunk. Some married taxpayers recently learned that the hard way when their business deductions landed in the U.S. Tax Court.
Sarkin v. Commissioner provides a valuable overview of how the IRS and the Tax Court determine if expenses qualify as deductible business-related expenses — specifically, the factors they consider when assessing whether an activity was engaged in for profit.
The taxpayers opened an urban planning firm in South Africa in 1997. By 2004, they’d relocated to the United States. In 2011, after having been unemployed since losing his job in 2009, the husband returned to South Africa. He converted his previously owned apartment into an office and used his time to renovate his mother-in-law’s 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, however, rejected the deductions, asserting that they weren’t engaged in a trade or business for profit. The taxpayers appealed.
The tax regulations provide a nonexclusive list of factors to consider when evaluating a taxpayer’s profit objective. The following seven factors favored the IRS’s stance:
- The manner in which the activity is conducted.The taxpayers didn’t have a written business plan. Moreover, the business didn’t have a separate bank account; all expenses were paid from the taxpayers’ personal checking account and with their credit cards.
- The time and effort devoted to the activity. The husband didn’t spend the entire two years in South Africa, and the court inferred that he didn’t spend much time on the business.
- The expectation of asset appreciation. An expectation that assets used in the activity will produce an overall economic profit can indicate a profit motive. But the taxpayers’ only asset was the previously owned apartment.
- The taxpayers’ success in similar or dissimilar activities. Without any evidence of earlier dealings in South Africa, the court didn’t know whether any success had occurred. And the renovation project wasn’t similar to the previous work the husband claimed to have completed in the country.
- History of income and loss. Although a series of losses in the initial stage of an activity doesn’t necessarily indicate a lack of profit motive, the goal must be to realize a profit on the entire operation. The taxpayers reported net losses for the relevant years and abandoned the business the next year.
- The amount of occasional profits. The business never earned a profit.
- The taxpayers’ financial status. A lack of substantial income from other sources can suggest a profit motive, while substantial income from another source can indicate the lack of profit motive. The husband was unemployed directly before the years at issue, but the wife had significant income from working as an architect. The business losses generated substantial tax benefits for the couple.
The court rated one factor as neutral — the expertise of the taxpayers or their advisors. The husband had the relevant work experience and requisite education to conduct a city planning and architecture business, but the court found no evidence to corroborate previous dealings in South Africa. Further, he had no expertise or experience in the renovation of personal residences.
Only one factor was found to favor the taxpayers: The court accepted the husband’s testimony that he derived no pleasure from conducting the business.
A costly loss in court
With the factors heavily going against the taxpayers, the court concluded no “actual, honest profit objective” existed. The expense deductions, therefore, were disallowed. If you’re looking to deduct business-related expenses, be sure you’re able to support your claims that the activity has an actual, defendable profit motive.
For additional information contact Nick Sarinelli, CPA, CFE or Doug Collins, CPA on (973) 298-8500 or visit our real estate services page.