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

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.

On a positive note, the change in rules around Sec. 195 costs is positive.  CPAs and other tax preparers have lost a lot of sleep over the years worrying about a missed Sec. 195 election.  Now, we can look at the substance of the expense.  If it is a Sec. 195 expense, as well defined, it gets treated as such.  The fact that a piece of paper was or was not in the taxpayer’s return in the year business began, is no longer controlling.  Many thanks to the I.R.S. on this point, as this change is, indeed, a small bit of simplification in over-complex Tax Code.

Note that this case, above, is a “TC Memo” case. The “memo” part tells the reader that the Tax Court judges view this case as insignificant.  That is, there is no new law or precedent being set.  The Tax Court views these conclusions as “old news” just being applied to a new taxpayer.

I can always be reached for questions or comments at (510) 797-8661 x237.