Business Activity or Hobby

M had been a co-owner of a successful construction business before selling his interest back to the firm and leaving. He then started a new firm that bought and renovated distressed properties, purchasing two, working on them, then selling one at a profit and one at a loss, for a total net loss. He decided that the real-estate market had deteriorated and that there was no point purchasing properties he might not be able to re-sell, so he terminated the business.

At year end, he deducted on his Schedule C those expenses related to the purchase, renovation and sale of the properties and took a net loss. But the IRS said that his activities amounted to a hobby, not a business, and denied the deductions. M. appealed the decision.

Held: For the taxpayer. In addition to the taxpayer being experienced and successful in the business, he also appeared to be operating in a businesslike manner, keeping good books and records, and trying to make a profit.

For example, he carefully tracked each project’s expenses in 2006 and 2007 as well as his net profits and losses. When he realized that the prospects for future profits were bleak, he cut his losses and closed the business, which demonstrated a profit objective. [Morgan et ux. v. Commissioner, T.C. Summ. Op.]

Tip. Here are factors to be considered when deciding if a client’s activity is geared to making a profit:

  • the manner in which the person carries on the activity;
  • the expertise of the person or his/her advisers;
  • the time and effort the person puts into the activity;
  • an expectation that assets used in the activity may appreciate in value;
  • the person’s success in similar or dissimilar activities;
  • the person’s history of profit/loss in the activity;
  • the amount of occasional profits, if any;
  • the person’s financial status; and
  • any elements of personal pleasure or recreation.

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