Long-term projects often lose money. They often do so for several years. This is the result of a project that needs capital to build infrastructure or to develop a new market or to capture market share. Taxpayers may be disappointed to learn that the tax losses coming from these long-term projects in the early years may be limited by the “hobby loss” rules. The WP Realty LP v. Commissioner, T.C. Memo. 2019-120, case provides an opportunity to consider the hobby loss rules in light of a long-term project.
Facts & Procedural History
The taxpayer is a partnership that owns a golf course located just North of Houston, Texas.
The partners are a management company as general partner with 1% ownership interest and an individual limited partner with a 99% ownership interest. The general partner was owned by another entity that, in turn, was wholly owned by the individual limited partner.
To start the taxpayer as a business, the general partner contributed the golf course and a lease to a golf association to the taxpayer. The limited partner contributed a $16 million promissory note. The taxpayer was to manage, develop, and operate the golf course.
The limited partner made significant contributions to the taxpayer over the years. The funds were used to develop and manage the golf course, which resulted in tax losses. In fact, the golf course never turned a profit.
The IRS audited the partnership tax return and proposed to disallow the losses as “hobby losses” under Sec. 183. Tax litigation ensued.
The Hobby Loss Rules
We have written about the hobby loss rules before. Here is a link to a prior court case involving the a motorcycle riding training business that describes the hobby loss rules. Here is another hobby loss case involving a car restoration business.
As noted in these other articles, there are nine factors that are to be considered in determining whether an activity is a hobby. No single factor is determinative. One must consider all of the factors as a whole.
If, taken as a whole, these factors show that the activity is a hobby, losses are generally disallowed until the time that the activity produces a profit. The losses can then be used to offset the profit.
Of the nine hobby loss factors, only two of the factors consider facts outside of the immediate business activity. This is important as these two factors may dictate whether long-term capital intensive projects are treated hobbies for tax purposes.
The Long-Term Project Factors
As noted above, there are two hobby loss factors that can be used to establish that long-term projects are not hobbies for tax purposes.
These two factors, which look beyond the current loss activity, consider:
- the expectation that assets used in the activity may appreciate in value and
- the success of the taxpayers in carrying on other similar or dissimilar activities
The evidence in this case suggested that the golf course was not expected to be profitable. This factor will usually favor the taxpayer who undertakes a long-term project.
The court did not find this factor in the taxpayer’s favor in this case. Unique to this case, the limited partner had previously sent the IRS a letter saying that he would not develop real estate for sale as part of this project. He did this in an effort to obtain nonprofit status for this project. The court notes that the limited partner then changed his mind and the taxpayer-partnership was formed to operate the golf course as a business. The court found this factor to favor the IRS’s hobby-loss determination given the limited partner’s prior letter.
The other hobby loss factor is whether the taxpayer was successful in other activities. The limited partner in the present court case had a track record for successfully developing large real estate projects in Texas. The court noted that these ventures did not necessarily produce profits during the time they were held, they did increase the value of the project which allowed profits to be realized on the sale of the projects. Based on this, the court found this factor in the taxpayer’s favor.
The court also considered the other hobby loss factors. But these factors are more mechanical when it comes to long-term projects. This includes factors such as whether the taxpayer operated like a business by keeping records, employed staff to regularly attend to the business, etc. The court found several of these factors for the taxpayer and several for the IRS.
In the end, the court concluded that the factors favor the taxpayer. It held that the tax losses were not limited by the hobby loss rules.
The Takeaway: Documentation is Key
The takeaway from this case is that those who incur tax losses from long-term projects should take care to document the hobby-loss factors.
Most of the seven mechanical factors should be easy to document. Reasonable minds could agree that he facts are either present or they are not.
The two other factors can be more difficult. But, as this court case shows, it is these two factors that may dictate the results for cases involving long-term projects.
Being able to show a track record of success on other long-term projects is key. This works even if the other ventures lost money during the operations phase, but earned a profit on the sale of the project.
A tax attorney may be able to help document these factors when it is a closer call. For example, if the limited partner in the present case could not have established this track record, he could have brought in another partner who did. Absent that, he may have even enlisted a consultant who had this track record and tried to build up the evidence of their track record. Alternatively, the taxpayer may find another way to define success. Success does not necessarily mean profit.