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No Deduction for Costs Before Real Estate Business Actually Began Training classes nondeductible; no election required for Sec. 195 start-up costs
Thomas J. Woody, TC Memo 2009 –93
Ron Cohen, CPA, MST By Ron Cohen, CPA, MST
Partner
Greenstein, Rogoff, Olsen & Co., LLP
This new case covers a number of common issues for real estate investors and small businesses.
Facts:
Mr.
Woody paid $22K to the Wealth Intelligence Academy, one of many groups
offering real estate investment training. I leave to the reader to
question the value of such training. Then, Mr. Woody diligently tried
to start a business of “buying, remodeling, and renting property.” When
that did not work, he changed his business to “flipping and
wholesaling” real estate. He did all this in 2004 and was able to
acquire a property on December 30, 2004 and was able to rent it out in
2005. His tax audit was for the tax year 2004.
Mr. Woody
deducted the $22K fee paid to Wealth Intelligence Academy plus car
expenses, supplies, meals and entertainment, computer and software
costs.
The Court's Conclusions:
1) No deduction allowed because he was not “engaged in the active conduct of a trade or business” during 2004.
2)
Worse, Mr. Woody’s payment of $22K did not qualify as a business
expense anyway. It was an educational expense incurred to prepare him
for a new career, i.e., real estate investor and landlord, rather than
to maintain or improve skills in an ongoing business or career.
3)
Worse yet, Mr. Woody acknowledged he couldn’t take any Sec. 195
(Start-Up Cost) deductions for the remaining car expenses, meals and
entertainment, computer and software, because he failed to file a
statement and make an election in his tax return to capitalize (defer)
and amortize those deductions. The Tax Court politely informed Mr.
Woody that in 2008, the I.R.S. issued Regulation Sec. 1.195-1T(b) and
-1T(d), whereby a Start-Up Election is not required to obtain Start-Up
cost amortization deductions for Start-Up expenses incurred after
10/22/04. However, in Mr. Woody’s case, only a small amount of his
costs were incurred after 10/22/04, so the rule change did not help him.
Discussion:
1) No deduction allowed because he was not “engaged in the active conduct of a trade or business” during 2004.
Under
long-standing rules, no business deductions are allowed until a
business actually commences. Just purchasing the property on nearly the
last day of the year was not enough to convince the court that I.R.C.
Sec. 195 did not apply. Under Sec. 195, businesses that are in the
investigatory and/or development stage cannot immediately deduct their
expenses (with a minor exception). Those costs get accumulated,
deferred and amortized over 15 years, with the amortization starting in
the month the business begins, generally defined as the month the
business started earning revenue. If the business fails, any
unamortized amount of Sec. 195 costs can be deducted at that time.
2)
Mr. Woody’s payment of $22K did not qualify as a business expense. It
was an educational expense incurred to prepare for a new career, i.e.,
real estate investor and landlord, rather than to maintain or improve
skills in an ongoing business or career.
Many clients come to us
with this issue. They are adamant the large expense of this type of
course is deductible because the people providing the course told them
so! For people who are working outside the area of real estate prior to
the course, there is no hope for a valid deduction.
Further, often these courses are wrapped around lavish hotel stays and cruise ship excursions.
Even
for people clearly working in the area of real estate, a taxpayer must
obtain and keep extensive documentation that the vast majority of the
trip was for time spent training and learning…or else the entire cost
can be disallowed as a personal vacation expense.
3) Sec. 195
Election. Since 1995, when Sec. 195 was enacted, the inadvertent,
unintentional error of failing to list out start-up costs on a
statement wherein the taxpayer clearly elects to amortize such costs
over time -- starting with the month business begins -- caused a
permanent loss of deduction for those start up costs. The only thing a
taxpayer could do was to deduct those costs if the business failed, was
liquidated or sold. Thankfully, that has changed as follows:
“No
formal election required. Effective for expenses paid or incurred after
Sept. 6, 2008 (the date that's 60 days after July 8, 2008, the date
that the regulations were published in the Federal Register), taxpayers
are not required to file a separate election statement to deduct costs
under Code Sec. 195, Code Sec. 248, (Organizational Costs) or Code Sec.
709 (Similar Partnership Costs). Instead, taxpayers are deemed to have
made the appropriate election for the year in which the active trade or
business begins, or the year in which the corporation or partnership
begins business.”
Summary:
The time period between
thinking about a new business and actually earning revenue (not profit,
just gross revenue) has many tax related risks. A taxpayer will often
want to deduct all cost immediately to reduce taxes that might be
otherwise due (on other income) and improve cash flow. Sec. 195 should
always be considered.
Training fees, which sometimes exceed the
cost of a year at a major University for a 3 to 5 day seminar, should
be viewed skeptically for many reasons. You can form your own judgment
about organizations with names like “Wealth Intelligence Academy.” In
any case, no matter what the organization says, often, these costs are
clearly non-deductible.
