Are Real Estate Investors Prohibited from Deducting Expenses if They Have Not Acquired a Property?

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July 16, 2009
James E. Duffy

For purposes of calculating taxable income, the Internal Revenue Code allows taxpayers to take a deduction for ordinary and necessary expenses that are incurred in a trade or business or in an activity engaged in for its production of income.  In order for such expenses to be deductible, they must be incurred after commencement of the operation of the business or commencement of the income producing activity.  If an expense is incurred before the business is operational, it is a “start-up cost.”  Start-up costs cannot be deducted until the year the active business begins and there are limitations on its deductibility.  In the year that the business begins, start-up costs can be deducted up to $5,000.  Generally, any start up costs over $5000 must be deducted ratably over a period of 180 months beginning with the first month of business operations.

In a recent case, the Tax Court took the position that, notwithstanding an individual’s extensive unsuccessful attempts to acquire real estate, he had not commenced the business of “buying, remodeling, and renting” real estate until he had actually acquired a property.  Woody v. Comm, T.C. Memo. 2009-93.  Accordingly, the Court disallowed deductions for costs incurred in connection with his activity of attempting to acquire property for sale or rent.

The facts of the Woody case are as follows.  In 2004, Mr. Woody began his real estate activities. He prepared a business outline describing his business “as buying, remodeling and renting property.” During 2004, he marketed his services via business cards, flyers and word of mouth. Throughout the year, he looked at many properties and made multiple offers to purchase properties.  In May 2004, he entered into a contract to purchase a property but canceled the contract after a home inspection revealed defects that the seller was unwilling to repair.  In October 2004, Mr. Woody paid $21,490 for training classes in real estate investment skills.  On December 30, 2004, he purchased a property.  The property was not rented at the time he bought it and he did not advertise it for rent in 2004.  On his tax return for 2004, he deducted amounts expended for automobile expense, meals and entertainment, the real estate training class, a computer and supplies as real estate business expenses. 

The IRS argued that Mr. Woody had not commenced the real estate business when he incurred the expenses.  The Tax Court agreed.  It stated that since Mr. Woody’s business outline stated that his business was “buying, remodeling and renting property,” until he began to buy, remodel or rent, he was not carrying on the trade or business.  Therefore, his business activities did not start until he purchased the property on December 30th and any expenses incurred before that date could not be deducted as business expenses.  This decision is certainly not good news for the real estate investor who incurs expenses prior to purchasing a property.

However, to the extent that this decision establishes a rule that acquisition of a property is a threshold requirement to deduction, it appears to directly conflict with a previous ruling by the Seventh Circuit Court of Appeals.  In the prior case, the Court of Appeals ruled that a corporation that had been formed to sell, install and maintain a product had in fact, commenced that business even though it had not made a single sale or installation. Cabintaxi v. Comm., 63 F. 3d 614 (7th Cir. 1995) revg in part and affg in part T.C. Memo 1994-316.  In that case, the Court of Appeals overruled the Tax Court where the Tax Court reached the same conclusion based on the same reasoning as it did in the Woody case.  Cabintaxi v. Comm., Id.  In the Cabintaxi case, a corporation was formed to sell, install and maintain automated transit systems.  For two years, the corporation attempted, unsuccessfully, to sell its system and incurred expenses in trying to make those sales.  The organizing documents for the business stated that the corporation was formed to engage in “the sale, installation and maintenance of automated transportation systems.”  The Tax Court concluded that since the corporation did not “sell, install or maintain such a system,” it therefore did not engage in the business for which it was formed and was not entitled to deduct the expenses.

The Tax Court’s decision was appealed and the Court of Appeals stated:

    [The Tax Court’s] reasoning confuses business activity with the purpose of the activity.  The principal purpose for which Cabintaxi had been formed was to make money, and to do this it had . . . to sell, install, or maintain automated transit systems.  But before it could sell, install or maintain its first system it had to sell the system, and to sell, it had to incur selling expenses.  Those expenses were an integral part of being in the business of selling automated transit systems.  Cabintaxi v. Comm., 63 F. 3d at __.

The Court of Appeals allowed the corporation to take a business expense deduction for the costs incurred in conducting its selling activities.

Similarly, in order for Mr. Woody to make money in the business of “buying, remodeling and renting property,” he had to buy property to rent or resell, and in order to buy property, he had to incur expenses of locating and attempting to acquire suitable property.  It is clear that he was actively engaged in his pursuit.  It appears that his business was established and operating (although unsuccessfully) prior to his purchase of the property on December 30th.  Consequently, it is not clear why result should be different in Woody than in Cabintaxi.

In Woody, the Tax Court relied on the fact that the taxpayer had not accomplished its stated business purpose as a basis for disallowing the deduction.  By contrast, in Cabintaxi, this reasoning was specifically overruled.  Accordingly, these cases appear to be in direct conflict.  On June 30, 2009, the taxpayer in the Woody case filed a notice of appeal in the Court of Appeals for the District of Columbia Circuit, so the Tax Court’s decision may not be the last word on this issue.

In the meantime, Cabintaxi appears to be good support for deduction of expenses of a real estate activity that is regular and continuous even if the investor has not successfully acquired a property either for rent or resale.  However, the Tax Court’s decision in the Woody case is nevertheless clear authority to the contrary and investors should proceed with caution.

If audited by the IRS, investors can fully expect that the IRS will take the position that expenditures made prior to acquiring their first property are non-deductible.  Accordingly, one should be careful to keep good records of his activities for the year.  If the amount of expenses is small, around $5,000, the less risky way to deduct these expenses is to treat them as a “start up” cost.

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