A recent Tax Court decision dealt with an individual who spent a large sum of money on travel and real estate education classes but was not entitled to deduct his expenses under Code Sec. 162 because they were incurred before his business began and because the lion’s share of them were for nondeductible educational expenses.
As an attorney who teaches several workshops a month on asset protection for real estate investments a common question always arises from the attendees – “can I deduct my education costs for attending workshops on real estate investing? I was told I could.” I have repeatedly stated that the education is non-deductible unless the expense is considered to be an ordinary and necessary business expenses directly connected with or pertaining to an existing trade or business. The key concept here is the enterprise must be functioning as a business when the expenses are incurred. Until the business is functioning as a going concern, expenses related to it are not ordinary and necessary Code Sec. 162 expenses but, rather, startup expenses that may be deductible over a period of time under Code Sec. 195. In other words if you are not already involved in real estate investing or brokering, the expenses incurred for educational workshops are not deductible on your 1040 schedule C. This is exactly what Thomas Woody discovered when he was audited.
Facts. In early 2004, Thomas J. Woody started investigating the real estate market so that he could buy properties for investment or rental purposes. He created a name for his sole proprietorship venture (Value Property Investments) and began marketing his services via business cards, flyers, and word of mouth. Mr. Woody went so far as to create a business plan outlining his strategies, markets, and other items. However, by late 2004 Mr. Woody had not yet purchased or sold any real estate. Mr. Woody decided that he needed to sharpen his real estate investment skill and in October of 2004 he paid $21,490 to the Wealth Intelligence Academy for certain training classes, which he subsequently attended.
Despite taking courses, obtaining an EIN number for his business, obtaining a small business loan, and credit cards in the name of his business, Mr. Woody did not engage in any actual real estate activity until Dec. 30, 2004, when he bought an investment property.
On his 2004 tax return Mr. Woody claimed $23,373 of expenses on Schedule C, consisting of the cost of his training classes and expenses for car expenses, supplies, meals and entertainment, and computer and software costs. The IRS denied the claimed expenses on the grounds that Mr. Woody was not engaged in the active conduct of a trade or business. Mr. Woody appealed to the Tax Court.
No business deductions until business actually commences. The Tax Court pointed out that in determining whether a trade or business exists, the courts have examined: (1) whether the taxpayer undertook the activity intending to earn a profit; (2) whether the taxpayer was regularly and actively involved in the activity; and (3) whether the taxpayer’s activity actually commenced. The Tax Court found Mr. Woody failed to satisfy the 3rd element of the test. The Court stated that until Mr. Woody actually began to buy, remodel, or rent— i.e., to perform the activities for which he organized Value Property Investments—he was not carrying on a trade or business for Code Sec. 162 purposes. And until that time, none of his expenses could be claimed as Code Sec. 162 expenses.
The Tax Court found that plausibly Mr. Woody’s activities did not rise to the level of a trade or business until he purchased investment property in December of 2004, and subsequently began renting it out. Thus, the Court held that expenses incurred prior to the start of his active trade or business began would be, by definition start-up expenses under Code Sec. 195 rather than ordinary and necessary business expenses under Code Sec. 162.
Further, the Tax Court stated that the $21,515 for workshops and training—was an educational expense incurred to prepare for a new career, i.e., real estate investor and renter, rather than to maintain or improve skills in an ongoing business or career. It was therefore not deductible under Code Sec. 162. If Mr. Woody wanted to amortize his expenses as a start up expenses under Code Sec. 195, the expenses could be deductible if Mr. Woody incurred the expense in connection with the operation of an existing active trade or business. Mr. Woody did not have an existing active trade or business set up for real estate investing e.g., a corporation established specifically for this activity. Thus, because Mr. Woody lacked an existing active trade or business the Court looked to Mr. Woody to determine if he was personally involved in a real estate and found he was not.
This case illustrates how important it is for individuals who wish to start a real estate career must get their business set up ASAP before incurring costs; otherwise, they may find their costs are non deductible.
A copy of this case can be found in the Documents of Interest section of our website.
Posted by Clint Coons, asset protection attorney, Seattle, WA