Whoops: No “Trade or Business”, No Deductions
Some folks think the mere expenditure of shekels equates to a tax deduction.
Au contraire – as recently found out by Mr. Ohana (right – Ohana, not Obama) who pled mercy to the Tax Court, though to no avail.
The Internal Revenue Code says certain expenses are deductible only if they are incurred in carrying on a trade or business. Although the Code doesn’t define “trade or business,” the Supremes have plugged that little hole by stating that a bloke is engaged in a trade or business only if the taxpayer is involved in the activity with continuity and regularity, the primary purpose of which is the derivation of income or a profit.
Ohana owned two rentals in Israel, and purchased his first “business” property in California in 2005, shortly thereafter selling one of the rentals, using the proceeds to purchase a second Golden State property, which he intended from the start to tear down and replace. Initially, however, he made only limited repairs, rented it out and engaged a real estate management company to handle ongoing maintenance. And in a real big “whoops,” Ohana indicated on the deed that he eventually intended to make this property his primary residence. Not only that, but on the later loan application (for a construction loan to fund the building of a new house on the property, he told the prospective lender that he would use the loan proceeds to build a primary residence, rather than invest in a business!
It gets better – he did tear down the old and then build a new house on the property in question, then enrolling his daughters in the local school system, and eventually moving into the new house which, by the way, had a specially designed front door with a peephole positioned such that the five foot four Ohana could reach it!
Though the taxpayer did maintain records of his real estate income and expenses, he did not keep records regarding the time he spent on his real estate “business” activities. (His day job, by the way, was that of a senior executive position with a high tech company, requiring “constant” travel and long hours.)
Result: Revenooers disallowed the amounts deducted on Ohana’s 2007 to 2009 tax returns as not qualifying as related to his real estate “trade or business,” and further asserted the substantial understatement penalty.
In agreeing with Uncle, The Court further pointed out that merely spending money with a view toward creating value isn’t the same as engaging in an activity designed to ultimately produce a profit – especially when the facts show that the expenditures eventually led only to the creation of a bloke’s personal residence (with an appropriately positioned peephole).
CONSULT YOUR TAX ADVISOR – This article contains general information about various tax matters. You should consult your CPA regarding the implications to your own particular situation.
Jeff Quinn, the author of this article, is a stockholder in Ashley Quinn, CPAs and Consultants, Ltd., with offices in Incline Village and Reno. He can be reached at 831-7288, welcomes comments at email@example.com, and invites readers to consider his other commentary at http://blog.nolo.com/taxes.