With many real estate markets on the rebound, real estate investors are resuming house-flipping strategies to reap profits by, among other benefits, deducting large amounts of related expenses. But those expenses are deductible only if incurred in connection with a “trade or business.” And, as the taxpayer in the recent case of Ohana v. Commissioner learned the hard way, a trade or business requires more than just vague intentions to sell at some point.
Flipper claims expenses
In 2005 and 2006, the taxpayer bought houses in Saratoga and Palo Alto, California. He initially lived in the Saratoga house and rented the Palo Alto house.
During that time, he worked full-time in an executive position requiring long hours and extensive travel. Nonetheless, the taxpayer claimed to run a real estate business in which he planned to make money by flipping houses: that is, buying a house with the intent to fix it up and sell it at a profit. To avoid the risk of a down market, his strategy was to move into the house and live in it until the market was more favorable.
The taxpayer bought the Palo Alto house with the intent of tearing it down and building a new one. On the record deed, he checked a box indicating he intended to eventually make the house his primary residence; he also obtained a residential mortgage for the construction. In late 2009, he moved into the new Palo Alto house and rented out the now-renovated Saratoga house.
The taxpayer claimed more than $280,000 in nonrental expenses in the years 2007 to 2009. The IRS filed notices of deficiency disallowing all of the claimed nonrental expenses, and he appealed.
Tax Court weighs in
The U.S. Tax Court weighed whether the taxpayer’s activities amounted to being in a trade or business. To be engaged in a trade or business, a taxpayer must be involved in the activity in question with continuity and regularity for the purpose of garnering income or making a profit.
Although the taxpayer in this case was heavily involved in his real estate projects, he wasn’t continuously or regularly involved in the business of buying and selling real estate. As the court noted, he didn’t sell or buy a single property during the relevant period.
The Tax Court also found that the taxpayer’s primary purpose in engaging in the real estate activity—which revolved around properties that either were or became his homes—wasn’t for profit. It first considered the Saratoga house, observing that—though the taxpayer had begun to rent it out in 2009—he’d never tried to sell it. The court added that the taxpayer had failed to record any of his expenses for the home, so the deductions would have been denied for lack of substantiation.
As to the Palo Alto house, the taxpayer argued that the expenses incurred in building the new home weren’t personal because he intended to make a profit on its eventual sale. But, the court noted, referencing a prior case, if hoping to eventually sell a house at a profit was sufficient to establish a profit-making intent, “rare indeed would be the homeowner who purchased a home several years ago who couldn’t make the same claim.”
Regardless, the facts showed that the taxpayer had always intended to make the new Palo Alto home his personal residence. When he bought the property, he told third parties it was to be his primary residence. He enrolled his children in the Palo Alto school system for the 2008 and 2009 years. And, his loans were the type one would obtain for a primary residence.
The court also pointed to “minor touches” that made the home less marketable for sale and more useful for the taxpayer. These included a custom-built door with a peephole low enough for the 5-foot, 4-inch taxpayer to see out of it.
Look before you flip
House flipping may seem like an easy path to great profits, but that’s not always the case. Work with your tax advisor to ensure you can defend any deductions you take against IRS scrutiny.
Sidebar: Taxpayer’s use of tax preparer didn’t preempt penalties
In Ohana v. Commissioner, the U.S. Tax Court upheld the underpayment penalties assessed against the taxpayer. (See main article.) A substantial underpayment exists if the understatement exceeds the greater of 10% of the amount of tax required to be shown on the tax return or $5,000. An additional issue in the case was whether the taxpayer had a reasonable-cause-and-good-faith defense.
Among other things, the court considered whether he’d actually relied in good faith on his tax preparer’s judgment — and concluded that he hadn’t. The Tax Court noted the general rule that a taxpayer can’t avoid his or her duty to file accurate returns by placing responsibility on an agent such as a tax preparer.
Moreover, taxpayers have a duty to read their returns to ensure that all income items are included. Given this particular taxpayer’s unusually focused attention to detail in other areas of his life, the court didn’t find him credible when he said he’d never once looked at his tax returns or checked his accounting records against his returns.
Seek the services of a legal or tax adviser before implementing any ideas contained in this blog. To reach a financial advisor at Lane Gorman Trubitt PLLC, call (214) 871.7500 or email firstname.lastname@example.org.