Could a startup real estate business deduct losses beyond current property income when its operations showed a genuine profit motive?

Subject

Businesslike real estate operations showed a genuine profit motive

Plain-English summary

Virginia allowed the couple's full Schedule C real estate deductions and abated the assessments. They built homes and bought condominiums intending to sell or rent them, but large startup, renovation, marketing, mortgage, and construction expenses produced losses in 2005 and 2006.

The wife was a licensed realtor, the business held a local license, kept separate books, marketed properties through publications, brochures, flyers, and open houses, and consumed about 25 hours per week. Expected property appreciation also counted toward overall profit.

Virginia found that early losses during startup and expansion did not outweigh the businesslike operation, expertise, effort, and appreciation objective. The activity was conducted for profit rather than as a hobby.

What this means for you

• Current losses do not automatically make an activity a hobby.
• Separate records, licenses, advertising, expertise, and substantial weekly effort support profit intent.
• Expected asset appreciation is particularly relevant for real estate.
• The analysis considers all facts; no single factor controls.

Common questions

How much time did the couple spend on the activity?

Approximately 25 hours per week.

Did the lack of profit in 2005 and 2006 defeat the deductions?

No. They were startup and expansion years, and other evidence showed a profit objective.

Citations and references

• Va. Code §§ 58.1-301, 58.1-322, and 58.1-219.
• IRC § 183.
• Treas. Reg. § 1.183-2(b).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 09-122

Original ruling text

August 7, 2009

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you seek correction of the individual income tax assessments issued to * (the "Taxpayers") for the taxable years ended December 31, 2005 and 2006.

FACTS

The Taxpayers, a husband and wife, are Virginia residents. They purchased several plots of residential land on which they built homes. They also purchased several different condominium units. The Taxpayers intended to either sell or rent the residences.

During the taxable years at issue, the Taxpayers incurred significant expenses stemming from building and renovation, marketing and mortgage interest, which they reported on their federal Schedule C. The resulting losses offset the Taxpayers' salary and investment income, as well as any income generated by the properties themselves.

Under audit, the Department concluded that the Taxpayers' real estate activities were not engaged in for profit. As a result, the auditor limited deductions claimed on the Schedule C to equal the income generated by the properties. This resulted in assessments of additional tax and interest.

The Taxpayers have appealed the assessments and contend that their real estate activities were engaged in to make a profit and that they were entitled to deduct all expenses incurred from their real estate operations.

DETERMINATION

Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. For individual income tax purposes, Virginia "conforms" to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI). Income included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Va. Code § 58.1-322.

As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. However, the Department retains the authority to adjust FAGI where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the Internal Revenue Code (IRC). See Va. Code § 58.1-219.

Under IRC § 183, deductions can be disallowed for activities not engaged in for profit to the extent that the expenses exceed income generated by the activities. The determination whether an activity is engaged in for profit is determined by taking into account all of the facts and circumstances of each case. Taxpayers must have the objective of making a profit.

Treas. Reg. § 1-183-2(b) identifies nine factors that should be taken into account when determining whether an activity has a profit motive: 1) The manner in which the taxpayer carries on the activity; 2) the expertise of the taxpayer or his advisors; 3) the time and effort expended by the taxpayer in carrying on the activity; 4) expectation that assets used in the activity may appreciate in value; 5) the success of the taxpayer in carrying on other similar or dissimilar activities; 6) the taxpayer's history of income or losses with respect to the activity; 7) the amount off occasional profits, if any, which are earned; 8) the financial status of the taxpayer; and 9) elements of personal pleasure or recreation.

The regulation makes it clear that all facts and circumstances must be considered in determining if an activity is engaged in for profit. The regulation further states that no one factor is determinative and that consideration is not necessarily limited to these nine factors.

Although the Taxpayers' real estate activity did not make a profit during the 2005 and 2006 taxable years, the Taxpayers provided significant documentation concerning their activities with regard to their real estate activities. The auditor concluded that the Taxpayers did not meet some of the factors used to determine if an activity is conducted with a profit motive. The auditor determined the Taxpayers did not spend enough time conducting the activity.

An examination of the evidence shows that the wife is a licensed realtor. She has a business license in the locality in which she operates and keeps separate books and records of her real estate activities. The Taxpayers have advertised their residences in several local magazines, in brochures, flyers and through open houses. In addition, the Taxpayers spent approximately 25 hours per week engaged in the real estate activities. These facts indicate that the Taxpayers' carried on their real estate activities in a business like manner, had the expertise to conduct such a business, spent sufficient time and effort in carrying on the activity, exhibited success in similar activities, and did not engage in the activity for recreational purposes.

Under the regulation, the term "profit" includes the appreciation in the value of assets used in the activity. Thus, even though current operations may not generate a profit, an overall profit may result when appreciation in the value of the assets used in the activity is realized as income. The regulation indicates that this factor is more significant in real estate activities. In the instant case, the Taxpayers are engaged in the purchase and subsequent leasing and sale of real properties in a market that was showing significant growth during the taxable years at issue. It is, therefore, reasonable to assume that the Taxpayers intended that their property would appreciate in value.

During the taxable years at issue, the Taxpayers were in the process or starting up and significantly expanding their business. Under the regulation, a series of net losses during the initial or start-up years of an activity would not necessarily be an indication that the activity is not engaged in for profit. Thus, the fact that the Taxpayers incurred significant losses for the taxable years at issue is not strong evidence in this case that the real estate activities were not conducted for profit.

After weighing all the facts and circumstances in this case, including the Taxpayers' other sources of income for the taxable years at issue, I must conclude that the clear preponderance of the evidence supports a finding that the Taxpayers did conduct their Schedule C business for profit. Therefore, they are entitled to claim the full deductions generated by their real estate activities. As such, the assessments of income tax and interest for the 2005 and 2006 taxable years will be abated.

The Code of Virginia sections cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-2052508831.B