There are quite a few uses for raw land. It can be used for just about any type of business activity.
If someone purchases raw land and starts to take steps to prepare the land for a business, how one characterizes the intended business use can allow or limit the deductions related to the property.
The recent Safaryan v. Commissioner, T.C. Memo. 2021-138 case provides an opportunity to consider this issue. In the case, the taxpayer described his real estate activity as one that required extensive preparation of the land, which in turn meant that his current year’s tax deductions were not allowable. A narrower description of the activity could have led the court to reach a different conclusion.
Facts & Procedural History
The taxpayer worked full-time as an engineer.
He purchased raw land with the intent of developing the land to be an organic farm. He would then enter into sharecropping arrangements with farmers.
The land was purchased in 2012 or 2013. From then until 2014, he installed a water tank and a rainwater collection system and began preparations for a U.S. Department of Agriculture (USDA) certification.
In 2015 he constructed a nonlivable outdoor structure on the property.
For his tax returns, he reported the expenses for the real estate in 2015. Specifically, he file a Schedule C for the land that reported no income and the following deductions: $12,700 of car and truck expenses, $5,580 of travel expenses, and $6,783 of other expenses.
The IRS audited the 2015 tax return and disallowed the car and truck expenses and other expenses as not ordinary and necessary. It disallowed the travel expenses for lack of substantiation.
Tax litigation ensued.
Trade or Business Expenses
The general rule is that expenses are deductible if they are for a “trade or business.” The phrase “trade or business” is a term of art. It refers to actions to earn a profit or income. It is something more than a hobby and more than an investment.
Whether an activity is a “trade or business” is often disputed by the IRS. The focus is often on when the activity rose to the level of being a trade or business.
The courts have said that a trade or business starts when the business has begun to function as a going concern and performed the activities for which it was organized.
Expenses before this time are classified as “start-up” or “pre-opening” expenses subject to Section 195. Section 195 limits start-up expenses. These expenses are generally to be accrued in a “work in process” or “construction in process” account and deducted starting in the year that the trade or business actually starts.
When Does a Trade or Business Start?
The question, in this case, was when the real estate activity was a trade or business.
Just as the court did in this case, the courts have generally evaluated this issue by considering three factors:
- Whether the taxpayer undertook the activity intending to earn a profit;
- Whether the taxpayer is regularly and actively involved in the activity; and
- Whether the taxpayer’s activity has actually commenced.
Naturally, the IRS attorney argued that these factors were not met:
Respondent highlights as an example, and in support of his position, that petitioner husband never accomplished the first step in his business plan, i.e., the construction of the nonlivable outdoor structure. Respondent further emphasizes that petitioner husband failed to complete the other steps in the business plan, namely: (1) the procurement of an organic farming certification from the USDA, necessary to lease the property for organic farming; and (2) the completion of the irrigation system, necessary for farmers to grow crops in a barren land such as the Mojave Desert. Respondent acknowledges that petitioner husband conducted a number of experiments on the property but asserts that these activities are insufficient to demonstrate that the Paradise Acres venture was an active trade or business for purposes of section 162(a).
And naturally, the taxpayer made just the opposite arguments:
On brief petitioners argue that the procurement of an organic farming certificate was not a prerequisite for the Paradise Acres venture to commence because the land could be leased for nonorganic farming or for another purpose. Therefore, petitioners assert, procuring an organic farm certificate was a means to make “additional profit” rather than a requirement for petitioners to lease the property for farming. Petitioners further assert on brief that petitioner husband was “actively managing and engaging” with customers with respect to the property during 2015 and received propositions from prospective customers interested in using the property for breeding dogs, developing a prickly pear farm, and growing cannabis.
Both positions are slightly off point. The test is whether the activity actually commenced. The facts listed by the court in its opinion suggest that the activity had not commenced. The activity was to be a sharecropping rental arrangement with farmers. The facts do not suggest that the farm was ready and able to be rented to farmers.
Based on this, the court concluded that a business had not actually commenced. There was no going concern in 2015.
The result is that the taxpayer’s expenses were not deductible in 2015. All is not lost, however. The expenses may still be deductible in the year the business starts and/or when the business activity is sold or abandoned.
This court case does not break new ground. It sets out the general rule that business expenses are not deductible until the business is capable of operating. This depends on how the taxpayer presents or describes the business activity to the IRS on audit.
For example, the taxpayer, in this case, could have presented the business as one to rent property to dog breeders, since the land was probably already ready for that type of activity. The deductions may have been allowable in 2015 for that type of activity. By presenting the activity as an organic farm that required extensive changes and certification, the taxpayer set a standard that could not be met in 2015.
This is one of those areas where real estate tax planning can help. This type of planning may include analyzing the optimal type of activity for the real estate and coming up with a plan for documenting the activity.