GRAY area alert: deducting real estate education

[Michael Plaks]

This question is very common and sounds very straightforward: as an investor, can I deduct my real estate education?

Warning: you will not get clear answers from this post. Instead, you will likely get confused. Welcome to the Taxation Gray Area club! Now allow me to show you why this is such a controversial issue.

1. Two types of deductions: "before" and "after."

The tax code has two very different treatments for business expenses. Let's say that you paid $20k to some marketing firm to create and distribute your promotional videos. If it happens after your business has already started, then the entire $20k is deductible as "ordinary and necessary" business expense under Section 162 of the tax code. (Yes, these section numbers are important.) 

However, if it happened before your business started, then it is called start-up expenses under Section 195 of the tax code. And the result is very different: $5k is deductible right away, and the remaining $15k is slowly deductible ("amortized"): $1k per year over the next 15 years. Not nearly as helpful as $20k right away.

2. When did the business start?

Maddeningly, this question remains very controversial and somewhat subjective. We have a lot of court cases to analyze, and unfortunately they are clear as mud. One court case says that you don't have a business until you buy your first property. Another court case says that you might operate a business even when you have no sales and no gross receipts. Huh? Exactly.

Accountants more or less have a consensus that for landlords, your business starts when your first property is ready and available for rent. For wholesalers, your business starts when you start making offers. As you can see, even these two formulas leave room for interpretation.

3. Can we deduct education in full after the business started?

Usually yes, but there is a "but." To be deductible, education needs to be specifically connected to the business you operate. If you have just one long-term tenant in your house hack duplex, and you're taking a $30,000 guru course on making money from assisted living or storage facilities or on running a syndication - it is probably not deductible under Section 162. 

In fact, even if the training course is related to property management, claiming that you needed to spend $30k on education while collecting merely $15k in rent per year is a flimsy position. 

4. So, if I have not done any deals, the education is a start-up expense, right?

Not so fast. Section 162 prohibits deducting of educational expenses if they qualify you for a new trade or business. Basically, they do not want lawyers to deduct the cost of law school and doctors to deduct their medical school - which sort of makes sense. 

Similarly, my colleagues often argue that real estate education is not deductible when you have not started investing. In their support, they point to the 2009 Woody Tax Court case which concluded that Mr. Woody's $21k real estate education would not be deductible. However, I don't necessarily agree with citing this case. The Court did say that this expense was not deductible, but it specified that it was not deductible under Section 162. The Court did NOT explicitly indicate whether or not it would qualify as Section 195 start-up costs. And the hints that the Court inserted in their decision could be interpreted both ways.

I'm not aware of another court case where this question was addressed conclusively. If you know of such a case, please chime in. Without such a precedent, I believe that eligibility of real estate education for Section 195 start-up costs remains controversial, aka gray area.

5. Is it education or something else?

More gray area! When you sign up for BPCON - is it education or networking? When part of your training cost is software that you will be using for your deals - is it education or an asset that will be placed in service once you start using it? When you hire a business coach - is it education or consulting?

So what do we do?

Remember I promised you no clear answers? I kept my promise. And if I did a half-decent job with this post, I hopefully convinced you that finding an answer for your specific situation is not a DIY project. Ask an experienced real estate accountant. And don't be shocked if you ask two of us, and we give you two different answers. This is the very definition of gray area.

PS. And here're some earlier relevant Bigger Pockets discussions if you want to get even more confused:
https://www.biggerpockets.com/forums/51/topics/484779-deduct...
https://www.biggerpockets.com/forums/519/topics/1105587-how-...
https://www.biggerpockets.com/forums/51/topics/1164415-ne-re...

[Jason Watson]

Yeah, the whole real estate investor seminar stuff is always funny to me. I doubt any of my to investor clients took a class. They were a) smart and b) knew money and c) poked around on the world wide webs a bit. I'm sure I've offended someone...

Nonetheless, there is a piece that might be missing from the post. Education does not need to be connected to your work per se, but rather improve your current work skills (or be required as part of your job with CEs for attorneys, accountants, etc.).

Here is the verbiage direct from the IRS. Before I click the ol' paste button, there are as many tax court cases allowing and disallowing MBA deductions for business owners. Even with identical facts. All depends on the court you get, and if they are having a bad day or not.

I do like the Section 195 and Section 162 intersection that you illustrate. Ok, here we go-

You can deduct the costs of qualifying work-related education as

business expenses. This is education that meets at least one of the
following two tests:

• The education is required by your employer or the law to keep your
  present salary, status or job. The required education must serve a bona
  fide business purpose of your employer.
• The education maintains or improves skills needed in your present work.

However, even if the education meets one or both of the above tests, it is not qualifying work-related education if it:

• Is needed to meet the minimum educational requirements of your present trade or business or
• Is part of a program of study that will qualify you for a new trade or business.

You can deduct the costs of qualifying work-related education as a
business expense even if the education could lead to a degree.

[Jason Watson]

Now the question becomes, does your rental or real estate activities rise to Section 162?

The definition of a “trade or business” comes from common law, where the concepts have been developed and refined by the courts over time. The Supreme Court has interpreted “trade or business” for purposes of Section 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making a profit.

We would argue that rentals and general real estate investments fall under this auspice otherwise you wouldn’t do it. Sure, we all want that short-term tax loss to offset other income, but ultimately you want to make money.

However, in Grier v. United States, 120 F.Supp. 395 (D.Conn. 1954) the taxpayer lost. How?

Edgar Grier inherited a house from his mother that she had rented out for many years to the same tenant. This same tenant continued to occupy the property until Grier sold it 14 years later. Over the years, little management work was required, but Grier did take care of such details as replacing the furnace. The IRS and court found that the house was an investment, not a business for Grier. The court noted that this was the only rental property Grier had ever owned and concluded that his landlord activities were too minimal to rise to the level of a business.

Has Grier been updated?

[Michael Plaks]

Quote from @Jason Watson:

Nonetheless, there is a piece that might be missing from the post. Education does not need to be connected to your work per se, but rather improve your current work skills (or be required as part of your job with CEs for attorneys, accountants, etc.).

I don't think it was missing. What you're talking about is part of my #3. Basically, all RE education improves an investor's current skill and falls under Sec 162 (your other comment  about Sec 162 eligibility notwithstanding). Rarely an issue, save for the abusive scenarios I mentioned.

The fun part is education before you make any deals. Does it qualify for Sec 195 or not? I don't think there's a definitive answer.

[Michael Plaks]

Quote from @Jason Watson:

The court noted that this was the only rental property Grier had ever owned and concluded that his landlord activities were too minimal to rise to the level of a business.

Has Grier been updated?

Yes, it has.
https://www.biggerpockets.com/forums/51/topics/602045-pass-t...

[Jason Watson]

Hmmm... while I agree that for purposes of Section 199A there is a series of safe harbor tests, but I don't see a specific tax court case or statute that specifically changes, improves, overturns, etc. the decision in Grier. Sure, it's 1954... there must have been a zillion cases and whatnot since then.

And with Section 199A, you can use either the safe harbor or facts/circumstances to support 162 (frankly, the safe harbors are anything but safe, I'd take my chances on simply arguing continuous, regular, profit motive, etc.).

Perhaps DM me. Aren't you still cleaning up after getting hammered by rain? Hope things are OK.

[Jason Watson]

Quote from @Michael Plaks:

Quote from @Jason Watson:

Nonetheless, there is a piece that might be missing from the post. Education does not need to be connected to your work per se, but rather improve your current work skills (or be required as part of your job with CEs for attorneys, accountants, etc.).

I don't think it was missing. What you're talking about is part of my #3. Basically, all RE education improves an investor's current skill and falls under Sec 162 (your other comment  about Sec 162 eligibility notwithstanding). Rarely an issue, save for the abusive scenarios I mentioned.

The fun part is education before you make any deals. Does it qualify for Sec 195 or not? I don't think there's a definitive answer.

Yeah, I agree. Does Rev Ruling 99-23 help a bit?

Expenditures incurred in the course of a general search for, or investigation of, an active trade or business in order to determine whether to enter a new business and which new business to enter (other than costs incurred to acquire capital assets that are used in the search or investigation) qualify as investigatory costs that are eligible for amortization as start-up expenditures under § 195. However, expenditures incurred in the attempt to acquire a specific business do not qualify as start-up expenditures because they are acquisition costs under § 263. The nature of the cost must be analyzed based on all the facts and circumstances of the transaction to determine whether it is an investigatory cost incurred to facilitate the whether and which decisions, or an acquisition cost incurred to facilitate consummation of an acquisition.

So, the question becomes is it "investigation?" Are we using a real estate investment seminar as a tool to decide whether to go into the rental property business or not? Things that make you go hmmm...

[Scott Mac]

Well all of you tax pros--a question.

Let me give you a businessman's perspective on this.

Based on what you guys have said so far, I see this not as ambiguity, but (it might be) a choice available to me as to when I want to consider the business started up (for tax purposes).

In Texas for instance, currently the state allows the organizer, who would be me in this instance, to select a date to start the LLC.

If I intended to shelf a new LLC for a while to have it on hand, such as I were looking for partners in a deal- then that LLC even though active according to the Secretary of state of Texas, I would not consider that started up until some actual business transaction had started. More falling in with one of the IRS scenarios.

That would probably be post opening the bank account, post filing for an EIN, post selling membership shares to myself or others.

It seems like the IRS is simply giving me as the organizer, or managing member the ability to choose one or the other scenarios, with either a clause in the operating agreement, or written on the Articles of incorporation/formation, or simply by a Members Resolution.

I would suspect, and hope, that an IRS auditor would respect that verbiage included in the LLC paperwork, since there seems to be nothing that you guys are pointing out in the tax code that prohibits making that choice.

Although during an audit, a cross auditor with an unpleasant attitude, or who for some reason dislikes the client, or is just having a bad day might disallow it- causing either a fine or going to court making the client pay for that (And no one wants to be a test case $$$$$$).

But to me as a businessman that seems like a workaround if I were personally needing to take a large dollar amount right off ahead of doing business.

However I am by no means a tax expert. You guys all are. And I am proposing this as a question to you not as a solution.

As practicing tax experts, is this something that you guys would see a problem with.

Such as having an attorney put it forth in specific legal language in the LLC paperwork.

Knowing of course that it is an IRS untaught method to their people who Audit return (of our SIC codes)-- An unknown fish so to speak that might cause them to simply redline it costing the customer big Bucks $$$$$$$$$ (and anxiety).

The tax savings on a $30,000 write off should buy quite a few Mcdonald's cheeseburgers.

[Michael Plaks]

@Scott Mac

I think your take has several flaws.

1. Generally speaking, an investor/businessman's perspective is irrelevant when it comes to tax law. The most glaring example: "taxable income" is very different from actual profit as measured by cash received.

2. You cannot plan for IRS auditors. Even the better ones among them are no experts in tax law and often come up with (and insist on) totally random positions contradicting the law. They are trained in bank statement reconciliation and not in interpreting tax law. During Covid, a lot of the old guard retired. The new crop of the IRS auditors is extremely undertrained, and dealing with them is a royal PITA. And it is pretty random.

3. When taking tax positions, you plan for what a court might say, not an auditor. Traditionally, the courts give a lot more weight to what actually happened over what is written on paper. If there is a legal dispute over when a business started, they will examine when the actual business activities commenced and not what your lawyer wrote as an intention.

4. It also seems to me that you misinterpreted what those battles are about. The goal of an investor is usually to establish the start date as early as possible, not delay it. This is because having a business started opens the door to deductions. The IRS, on the other hand, tries to argue that the business has NOT started until a later date. This way they can disallow  or delay early deductions.

[Scott Mac]

Splendid response- thank you!

[Jason Watson]

I will piggyback. Most of us tax pro's are business owners. My wife and I grew our practice from our basement and we now have 68 employees. I 100% approach everything from a business owner perspective because I (and several other tax pro's) started a business with headaches, cash problems, employees, revenue searches, tough decisions, etc.

Then again, I know what you were saying Scott... and I didn't mean to take things too literally. But I am a business owner first, and a CPA second.

[Benjamin Weinhart]

I'll echo everyone else here while providing a bit of perspective of my own. I, like many of my colleagues tend to opt for the more conservative approach when analyzing tax legislation/litigation. That being said, I think there's also something to be said for the nature of the conference itself. Since BPCON is happening in Cancun, a well known vacation destination, that gives me large pause for thought on if this would be an allowable business deduction. I personally think that the person who wrote that article about tax deductibility took a very aggressive stance for the deductibility of business travel as they included verbiage of personal time in their rationalization.

I might personally be inclined to investigate further if one of my clients presented that specific case to me, and likely opt for not including it as deductions if they haven't begun operations yet. I haven't looked into it but I had a thought occur while writing this if you could argue that a % of the conference would be used for investigative purposes and the rest for business. With the inclusion of personal usage for the travel, that may very well push you over the threshold into disallowance.

I'll also say that I personally think that having a conference in Cancun versus a much more remote destination such as Birmingham, Alabama or even fully online may also provide some additional ambiguity. It's my personal opinion that meeting somewhere that isn't classically considered as a vacation destination would give you a stronger case in arguing for a business deduction (with online being the most straightforward). There may be personal things you can do, sure, but I feel it leaves less room for abuse. Also if you're bringing family along or just going by yourself for example.

I'll also piggyback a little from @Scott Mac 's question about what the state specifies in their own rules. Think of tax law as being it's own appendage on federal law. Of course federal law trumps any state laws that may exist. Using an outlandish example, my home state of Ohio could deem that land is now eligible for depreciation. You of course couldn't include it in your federal tax return, but there may be a mismatch in the state allowing something. When it comes to business rules such as those, the states often have different definitions for tax to fall more in-line with the internal revenue code. Just one of the ways our legal system can be very complex at times.

[Jeremy H.]

I tend to expense everything that is "necessary and ordinary"

If it's an extreme outlier position that most other real estate investors would not deduct - then I opt not to deduct it. If I can justify it, would improve or is necessary for the business then I'll deduct it. 

I know several people that are self employed that make anywhere from 90-150k a year and the deduct down to where they are making 30-40k a year. 

My goal is to just blend in with other real estate investors. I would think with enough "proof" you could deduct trips/masterminds and all of that 

[Michael Plaks]

Quote from @Jeremy H.:

My goal is to just blend in with other real estate investors. I would think with enough "proof" you could deduct trips/masterminds and all of that 

This does not work the same as blending into speeding traffic. But you will not believe me unless audited. And I hope that you will not be.

[Jeremy H.]

Quote from @Michael Plaks:

Quote from @Jeremy H.:

My goal is to just blend in with other real estate investors. I would think with enough "proof" you could deduct trips/masterminds and all of that 

This does not work the same as blending into speeding traffic. But you will not believe me unless audited. And I hope that you will not be.

 Hypothetically speaking - let's say someone replaced the countertops in their primary home at the same time they were rehabbing a rental property. Maybe the receipt for the countertops got mixed in with the rental property receipts and the countertops got deducted. Is an IRS agent going to personally come in to inspect the countertops?

My HVAC guy deducts literally everything

Thoughts?

[Michael Plaks]

This pack of gum (that I did not pay for) accidentally slipped into my pocket...
This bottle that I did not scan just got mixed with the other bottles that I did scan...
This receipt is not really for this pair of shoes, but I want to return it anyway...
Sorry that I dropped $10 ear buds into this Amazon return for $200 ear buds, it got mixed up...

Should I continue? 
Oh yeah, forgot to mention: all my pickleball buddies do this, too.

PS. Ask your HVAC guy to prepare your taxes. I promise, it will be a lot cheaper than hiring one of us.

[Jeremy H.]

Quote from @Michael Plaks:

This pack of gum (that I did not pay for) accidentally slipped into my pocket...
This bottle that I did not scan just got mixed with the other bottles that I did scan...
This receipt is not really for this pair of shoes, but I want to return it anyway...
Sorry that I dropped $10 ear buds into this Amazon return for $200 ear buds, it got mixed up...

Should I continue? 
Oh yeah, forgot to mention: all my pickleball buddies do this, too.

PS. Ask your HVAC guy to prepare your taxes. I promise, it will be a lot cheaper than hiring one of us.

 I have a CPA firm I use personally - but I still compile my receipts, and organize them - cost, date, project, purpose, vendor etc. Same with mileage - date, miles, to/from, purpose etc. 

I'm not sure I understand your analogy completely. Are you equating it to theft? And it doesn't matter who gets audited because everyone is wrong? 

Is the IRS going to come find the 2x4 that was used to reinforce a wall or build some shelving? 

[Michael Plaks]

It's rather simple. If you know that it was personal but deduct it as business - it IS... pick your favorite word:
- cheating
- stealing
- theft
- fraud

Just because it's unlikely to get caught does not change its nature.

[Jeremy H.]

Quote from @Michael Plaks:

It's rather simple. If you know that it was personal but deduct it as business - it IS... pick your favorite word:
- cheating
- stealing
- theft
- fraud

Just because it's unlikely to get caught does not change its nature.

 It's only cheating/stealing/theft/fraud depending on who you ask

The people telling me a man can turn into a woman and vice versa are the same ones telling me what cheating/stealing/theft/fraud is...

At the end of the day I'm a little fish - there's much bigger fish to catch out there. It doesn't make sense to spend $100 to go after $10...to me anyway. But then again I don't think a man can turn into a woman either. So what do I know?

[Benjamin Weinhart]

Quote from @Jeremy H.:

Quote from @Michael Plaks:

It's rather simple. If you know that it was personal but deduct it as business - it IS... pick your favorite word:
- cheating
- stealing
- theft
- fraud

Just because it's unlikely to get caught does not change its nature.

 It's only cheating/stealing/theft/fraud depending on who you ask

The people telling me a man can turn into a woman and vice versa are the same ones telling me what cheating/stealing/theft/fraud is...

At the end of the day I'm a little fish - there's much bigger fish to catch out there. It doesn't make sense to spend $100 to go after $10...to me anyway. But then again I don't think a man can turn into a woman either. So what do I know?

 I personally would ask the US Government, I guarantee you that their response would be that it's fraud. If you're doing so willfully, and that can be proven by an examiner, it actually gets upgraded to evasion which can have jail time of up to 5 years. In the past, smaller taxpayers such as yourself held a disproportionately higher audit risk since it's a lot faster to audit the little guy which makes their numbers look better. There has been talk of that changing a bit, but there's really no way to know for sure as the IRS (for good reason) doesn't publish their audit algorithm data anywhere.

Also, before you start saying anything about a statute of limitations, if you commit fraud/evasion on a tax return, the statute of limitations is unlimited. This means that a fraudulent return could theoretically come back at you (or your estate) 30 years down the line. The fines/penalties are also not cheap either. There are plenty of cases of people getting away with it, sure, but the IRS will eventually find out if you keep doing it.

[Scott Mac]

The way I look at it, "The Tax Man" is a (silent) partner in everything you do.

The same way as the bank is your partner in many things you do.

Both have a lot of power over you and dictate how you must pay them

This--->>>> https://www.youtube.com/watch?v=gMdcE8jdz70

[Kory Reynolds]

I enjoy how this thread devolved from "Education Expenses" into someone promoting tax fraud since "they'll never figure it out".

But...occasionally they do. And whether they find all of these little issues or not, it will still result in thousands of professional fees and many hours of your time to deal with it.

Then you need to look at the other side, if you are mis-stating your tax returns, you will also end up providing bogus numbers to banks (also not a good one to lie to), potential investors, potential buyers, impacting the value of your properties by over stating your expenses...

Honesty is a great policy.  Any tax advisor you happen to find that encourages sketchy positions or fraud on the position that "they probably won't find it" - run for the hills.  Want to know what happens? One of their hundreds of clients gets picked for audit...and then maybe another...and then maybe all of them. Patterns of bad behavior will always come back to bite you, whether it is yours or just the actions of the bad professional.

A bit of a departure - but great post on this @Michael Plaks, this is one that is confused all the time.

[Jason Watson]

Quote from @Scott Mac:

The way I look at it, "The Tax Man" is a (silent) partner in everything you do.

The same way as the bank is your partner in many things you do.

Both have a lot of power over you and dictate how you must pay them

This--->>>> https://www.youtube.com/watch?v=gMdcE8jdz70

 Hmmm... Yes and no. The IRS is not my client. While I remind people that the tax police exist, I am not the tax police. Yes, we must defend our profession. More importantly, I am fellow taxpaying citizen.

Having said that, we live in a world of gray waters... a reasonable tax position is all I demand of my clients and my team. Win lose or draw... just be reasonable.