Real Estate Sales Venture in Its ‘Developmental’ Stage Fails to Qualify for Business Deduction

The business expense deduction encompassed within Section 162 of the Tax Code permits taxpayers to claim a substantial range of expenses. One essential key, however, is that the expenses incurred must relate to an existing, active, ongoing business. If the expenses you’re incurring simply lay the groundwork for a future business, they do not qualify for the deduction, as a taxpayer couple seeking to sell lots on their upstate New York parcel of property found out in Chen v. Commissioner.

Albert Chen and Nai-Fen Chen purchased land in Greenville, NY in 1980. In 2003, the couple formulated a plan to subdivide the property and sell lots. The couple hired a land-use company to assist them. The company performed several necessary tasks, but as of February 2010, the couple had sold no lots, nor had they begun marketing the lots. The taxpayers claimed several costs related to the project as business expense deductions on their 2009 federal income taxes. The Internal Revenue Service disallowed the business expense deductions entirely, concluding that the taxpayers were not engaged in a trade or business regarding the property, but had simply made capital expenditures.

The US Tax Court agreed with the IRS’s view of the expenses. The court explained that Section 162, which governs the business expense deduction, does not encompass expenses a taxpayer incurred as part of “startup or preopening … before beginning business operations.” The court decided that the Chens’ situation mirrored that of a previous taxpayer who bought a large parcel of land zoned as agricultural property and hired a lobbyist to attempt to seek a zoning change from the local city council. In that case, the court ruled that the taxpayer’s expenses were preliminary and developmental in nature, and not eligible for the business expense deduction. The court also compared the Chens’ situation to another case where the taxpayer incurred expenses consulting real estate professionals and seeking to secure additional investors in his subdivision project. Because that taxpayer’s property “remained in the same undeveloped condition as when it was purchased,” he had a “potential business which never materialized,” meaning he could not claim the deduction.

The Chens testified that they planned to begin sales activities in 2010. However, in 2009, the couple engaged in no efforts to market the lots and secure sales contracts. The couple received no offers from potential homeowners in 2009. The expenses the couple racked up in 2009 related solely to the planning and development of the property, in the court’s estimation. The project, the court concluded, was still in an exploratory phase in 2009 and expenses related to it were not entitled to the business expense deduction.

The business expense deduction is an essential element of many taxpayers’ returns, allowing them to significantly reduce their total tax liability. As with any deduction, though, understanding the parameters and limitations of the deduction is vital. To make sure your claimed deductions comport with the Tax Code, talk to the experienced tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C. Their keen knowledge and awareness of the code and its regulations can help you ensure you avoid the pain of a deficiency and its related penalties. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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