Rental Business’ Failure to Commence Dooms Business Expense Deduction

House In recent years, buying and selling houses has become more difficult, leaving more people to pursue renting out houses they own but do not occupy and cannot sell. For these taxpayers, the tax code establishes clear criteria for what qualifies as a valid business and when they may claim a business expense deduction for their mortgage interest. These taxpayers should take note of a recent US Tax Court case that denied a Southern California couple the deduction because the couple did not meet all these criteria, thus allowing the Internal Revenue Service to disallow the couple’s business expense deduction.

Michael Hume and Dorsaye Dilani likely had high hopes for business success and profit when they purchased a San Clemente, California home originally built for 1930s movie star Ann Harding. The couple intended to rent the house out for vacations and special events. The couple’s purchase included a $1 million mortgage.

The business, however, never got off the ground. They obtained no renters. In fact, the couple never advertised the property’s availability, since the extent of repairs that the property needed was so great that the couple never got the home into a sufficient condition to be ready for business use. They eventually sold the property in 2012. Nevertheless, the couple claimed the mortgage interest they paid on the home as a business expense on their 2008 and 2009 tax returns. The IRS rejected the deductions, deciding that the interest payments qualified, if at all, for the residence interest deduction.

The taxpayers took their case to the Tax Court, where they represented themselves, and lost. The court distilled the fundamental issue down to one basic question: was the couple engaged in a business of renting the property during 2008 and 2009? Whether a taxpayer’s activities qualify as a trade or business involves three factors. First, the taxpayer must have started the activity intending to make a profit. Second, the taxpayer must regularly devote himself to the activity. Third, the activity must have actually started.

In Hume and Dilani’s case, they only went two-for-three. The court concluded that the couple bought the house intending to rent it out for profit and that they worked on their house rental business during 2008 and 2009. The problem for these taxpayers, though, was that, based on the evidence they provided, the court concluded that their rental business activity had not “actually commenced.” The taxpayers did not rent the property out and did not receive any income from the home during the years in question. They also did not attempt to rent the property, since they spent the entire period of 2008-2009 attempting unsuccessfully to bring the home into a condition suitable for rental.

In total, Hume and Dilani’s case did not demonstrate a “course of conduct… consistent with that of a person who believed he was renting or able to rent out the property during 2008 or 2009.” As a result, the court ruled that the couple had not commenced a business of renting out the home and could not claim the mortgage interest paid on it as a business expense.

For all businesses, large and small, the tax code contains many opportunities for deductions to defray one’s tax liability. For knowledgeable and diligent advice and representation regarding your business’ income tax deduction issues, consult the experienced tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C. Their skill and experience can help you ensure that your return won’t create problems for you down the road. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

More Blog Posts:

Dealing With Your Tenant’s Property Abandoned Within Your Rental Space, New York & New Jersey Real Estate Lawyer Blog, July 15, 2014
New York City Sets Aside Over $1 Million for Worker-Owned Cooperative Businesses, New York & New Jersey Business Lawyer Blog, July 7, 2014
USCIS Increases Investigations of L-1 Visa Holders and Employers, New York & New Jersey Immigration Lawyer Blog, June 25, 2014
Photo: Jerrynovak at Wikimedia Commons.