Some people are drawn into the real estate game largely for the potential tax benefits—done right, for example, you can leverage any real estate losses you sustain into some generous deductions for business expenses. There’s a catch, though: You can’t be engaged in your real estate activities just to generate losses. If the IRS finds that you lack a profit motive, it will limit and perhaps disallow your deductions altogether. One taxpayer recently learned that the hard way.
IRS rejects real estate deductions
In Long v. Comm’r, the taxpayer was issued a real estate broker’s license in California in November 2009. He never generated any income from his real estate activity in the years at issue, 2010 and 2011.
He did, however, claim deductions for expenses related to his real estate activity totaling $103,760 and $52,367 for 2010 and 2011, respectively. The IRS determined the taxpayer had income tax deficiencies based on the deductions and assessed accuracy-related penalties. The taxpayer appealed.
Tax Court finds no profit motive
Tax law allows business loss deductions only if the taxpayer is engaged in the underlying activity for profit. If the engagement wasn’t for profit, the law limits deductions to the amount of gross income generated by the activity. In other words, if the taxpayer in this case wasn’t trying to generate a profit from his real estate activities, he wasn’t entitled to any of his claimed deductions because he reported no gross income from those activities.
The U.S. Tax Court cited nine nonexclusive factors relevant to the determination of whether a taxpayer engaged in an activity for profit. It found that these factors weighed against the taxpayer’s claim that he engaged in real estate activities for profit. Several factors in particular worked against him:
Manner in which the taxpayer carries on the activity. Did the taxpayer carry on the activity in a businesslike manner? The court didn’t think so, noting, for example, that he’d failed to maintain complete and accurate books and records, have a business plan or accounting system, or open a business bank account or credit card. In general, keeping the business activity separate from other business endeavors helps support the intent of the business.
Time and effort expended by the taxpayer. The taxpayer had a full-time job for much of 2010 and 2011, and was also enrolled full-time in a competitive MBA program most of the period. The court found it unlikely that he’d spent as much, if not more, time on his real estate activities than his full-time job, as he claimed. Having a full-time job does not preclude a taxpayer from taking real estate losses, but it is always best to keep track of the hours spent on the real estate activity as support of participation in the activity.
Amount of occasional profits. The amount of profits in relation to the losses incurred can suggest the taxpayer’s intent. Because the taxpayer didn’t report any gross receipts or profits, instead reporting only substantial losses, this factor didn’t indicate a profit objective for the real estate activities.
Taxpayer’s financial status. The lack of substantial income from other sources can indicate the activity is engaged in for profit. Conversely, reaping significant personal tax benefits from an activity, without other evidence it’s engaged in for profit, indicates the activity isn’t engaged in for profit. The taxpayer’s reported income from salary or wages was $527,860 for 2010 and $117,888 for 2011. And he derived significant personal tax benefit from the real estate deductions — $103,760 in 2010 and $52,367 in 2011.
Walk the walk
There’s no such thing as a free tax break. If you want to take full deductions for losses on real estate activities, you’ll need to be able to prove that you engaged in those activities for profit. Please note that there are other hurdles to leap over to take losses for real estate activities that are out of the scope of this article.
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