Deductions for a newbie

[Jim M.]

So I am a brand-newbie at this, have not done a deal yet.  I realize that the very first thing I need to do is educate myself, which will probably take several months (which will put us into the next tax year) before I am ready to pull the trigger and make that first deal.  My question is, if I spend money now on educating myself (e.g., books, courses, biggerpockets pro membership, etc.) but don't actually begin investing in real estate until next year, will I still be able to deduct those expenses for this tax year?  Or do I need to have a real estate "business" set up first?

FWIW, I am a W-2 employee and also earned a small amount of 1099 income this year, by moonlighting at the same occupation as my full-time job.  My current occupation has nothing to do with real estate.

Thanks so much.  Looking forward to getting to know many of you here on biggerpockets as I begin my journey. :)

[Jason Vo]

If I were you, I would spend money to educate myself anyway and care less about tax deduction. But if you have some kind of 1099 income, then yes, you can claim under education or business expenses.  

[Jim M.]

Well, sure, I am going to spend the money anyway. But if I could get a tax deduction at the same time, hey, why not? :) 

Does it matter that my 1099 income is from a business that's completely unrelated to real estate?

[Nicole Bernshaw]

Jim, I am copying the response that Brandon Hall, CPA, sent me when I asked a similar question a couple of weeks ago:

"When did the education occur? If before you did a deal, the education is non-deductible. If after you did a deal, we may have an argument to deduct it.

Education that qualifies you for a new trade or business is non-deductible. Education that allows you to expand upon current skill sets and bring more revenue/profits to a business can potentially be deductible."

This is not what I have been told by another CPA. I am currently looking for the IRS code that will clarify this for me. I too want to have my education to be tax-deductible. Unlike you, though, I went ahead and got the education before doing a deal.

[Jim M.]

Thanks, Nicole.  This raises two additional questions for me:

1. Even if "education" expenses aren't deductible before doing a first deal, what about other expenses like flying to see a property, or even biggerpockets pro membership?

2. Would making an investment on a crowdfunding site like realtyshares.com count as a "deal"?  I have done this already.

It bothers me that you got different answers from different CPAs.  I suppose the tax code does have some ambiguities or grey areas in it.

[Nicole Bernshaw]

1. Any expense associate with business is tax deductible. Everything you mentioned is tax deductible, education being the big question mark at this point.

2. Doing business as a sole proprietor is being in business. Therefore, your expenses associated with the trade of real estate are deductible. On the other hand, do not confuse investing a certain sum with expense. The sum that you are investing will either grow (in which case you will incur a gain and be taxed on the gain) or decrease (in which case you will incur a loss and get a tax deduction on that loss). The original sum of investment is only the starting point for tax calculations.

3. The tax code is sometimes subject to interpretation, which may explain the divergence of advice we are currently receiving on the subject of education.

[Natalie Kolodij]

Brandon is correct- If you're just doing research/educating yourself you're not a business yet. 

If that were the case people could spend $100k on guru courses each year and literally never do a deal and report losses as  a "business". 

There has to be a defining point where you're a business- and it typically comes down to when you have everything needed to operate. If you don't have properties to sell, rentals to rent, ect....what are you offering customers?

Investing is a little tricky in terms of how tax law can be interpreted because you're not just renting a store, stocking shelves, opening a door. 

You're putting in a lot of work on the front end to get inventory (ie: a house to flip, wholesale, a rental ect) to then sell to customers. But you're still not really in business until that happens. 

Especially on these topics I would find a real estate specialized CPA/EA (Brandon Hall is an excellent one) and listen to them rather than trying to teach yourself something they've spend years becoming an expert in. 

https://www.irs.gov/publications/p970/ch12.html

[Ashish Acharya]

@Jim M. It is good that you are thinking about the tax implications before getting into this. 

While agreeing with all the valuable information already posted, I stumbled upon one interesting case where tax court considered the educational cost as the Start up cost and could be deducted over the long term. 

This is the case (Thomas J. Woody v. Commissioner, TC Memo 2009-93 , Code Sec(s) 162; 195.) that is related to you.

Started investigating property: Feb

Put first contract (canceled): May

Bought first property: December 30th (He incurred education cost of 21k before December 30th)

Court decided that investor' s 21k education expense was not deductible as business expenses but would be considered, at best, the start up the cost. Start up cost are also deductible but are amortized over 15 years with the limit of 5k and subject to phase out. Start up cost have strict rules too and has to meet certain requirements. 

Here is the summary of the case  if you are interested.

In this case, the main question is when did the investor completed his start-up phase and became actively engaged in his business.

Whether a taxpayer is engaged in a trade or business is determined using a facts and circumstances test under which courts have focused on the following three factors that indicate the existence of a trade or business:

(1) whether the taxpayer undertook the activity intending to earn a profit;

(2) whether the taxpayer is regularly and actively involved in the activity; and

 (3) whether the taxpayer's activity has actually commenced.

“On the basis investor testimony, we may assume that he undertook this activity to make a profit and that he regularly and actively engaged in it. However, it is the third factor—whether investor business had actually commenced—that is determinative here.”

“In investor’s business outline, dated May 10, 2004, he indicated that he was starting Value Property Investments “for the purpose of buying, remodeling and renting property.” Therefore, until investor began to buy, remodel, or rent—i.e., to perform the activities for which Value Property Investments was organized—he was not carrying on a trade or business as contemplated by section 162(Business deduction).

Nonetheless, in order to resolve the matter before us, we do not need to decide whether investor's business started at the time he purchased the 1st property or at the time he held it out for rent, because, in any event, the expenses in question here all occurred before the purchase date, i.e., before December 30

If the earliest possible date investor was actively carrying on a trade or business was December 30, 2004, then any expenses incurred in that year but incurred “before the day on which the active trade or business” began, all the expenses incurred from January 1 through December 29, 2004--would be, by definition, start-up expenses whose deductibility, and possible amortization, is expressly dealt with by section 195(Start up amortization)."

Please talk to your CPA on this. thanks

[Natalie Kolodij]

@Ashish Acharya did this case go into details on whether the tax payer was previously involved in real estate investing in some capacity or if this was a totally new business for him? 

Typically any educational costs to place yourself in a new career are disallowed- I'd be curious to know more of the details on the case

[Natalie Kolodij]

Also...It looks like they disallowed the education expense all together. 

They allowed him normal start up expense  $5k max and amortized- this is normal 

Pertaining to the matter of this post though they ...DID NOT allow the education. Per the reasons already stated. 

"Mr. Woody’s largest expenditure in 2004–-$21,515 for workshops and training–-was an educational expense incurred to prepare for a new career, i.e., real estate investor and renter, rather than to maintain or improve skills in an ongoing business or career. It was therefore not deductible under section 162. See sec. 1.162-5, Income Tax Regs."

[Ashish Acharya]

Originally posted by @Natalie Kolodij:

@Ashish Acharya did this case go into details on whether the tax payer was previously involved in real estate investing in some capacity or if this was a totally new business for him? 

Typically any educational costs to place yourself in a new career are disallowed- I'd be curious to know more of the details on the case

Nope,the investor did not. I believe if he was previously involved in the real estate investing, there would be no case about this issue. The court/IRS would classify expenses as business deduction as it was already in the investor tax return.  

Thomas J. Woody v. Commissioner, TC Memo 2009-93 , Code Sec(s) 162; 195. That's the case, you can read about it. It is interesting. Let me know what you think. 

[Natalie Kolodij]

Originally posted by @Ashish Acharya:

Originally posted by @Natalie Kolodij:

@Ashish Acharya did this case go into details on whether the tax payer was previously involved in real estate investing in some capacity or if this was a totally new business for him? 

Typically any educational costs to place yourself in a new career are disallowed- I'd be curious to know more of the details on the case

Nope,the investor did not. I believe if he was previously involved in the real estate investing, there would be no case about this issue. The court/IRS would classify expenses as business deduction as it was already in the investor tax return.  

Thomas J. Woody v. Commissioner, TC Memo 2009-93 , Code Sec(s) 162; 195. That's the case, you can read about it. It is interesting. Let me know what you think. 

I just read through it. I read it as they disallowed the educational expenses (not even as start up expense) based on it being education fora  new career see above post 

[Ashish Acharya]

Originally posted by @Natalie Kolodij:

Originally posted by @Ashish Acharya:

Originally posted by @Natalie Kolodij:

@Ashish Acharya did this case go into details on whether the tax payer was previously involved in real estate investing in some capacity or if this was a totally new business for him? 

Typically any educational costs to place yourself in a new career are disallowed- I'd be curious to know more of the details on the case

Nope,the investor did not. I believe if he was previously involved in the real estate investing, there would be no case about this issue. The court/IRS would classify expenses as business deduction as it was already in the investor tax return.  

Thomas J. Woody v. Commissioner, TC Memo 2009-93 , Code Sec(s) 162; 195. That's the case, you can read about it. It is interesting. Let me know what you think. 

I just read through it. I read it as they disallowed the educational expenses (not even as start up expense) based on it being education fora  new career see above post 

 Yup not allowed as section 162, but I think based on the content, the taxpayer could have used section 195 (taking a risky position ). But as stated supra note 7, Mr. Woody has made no claim for section 195 treatment. 

[Jake Hottenrott]

@Jim M. - You have clearly asked a question that has inspired a bit of debate, which is good.  Debate works as a way to break apart these complicated tax matters and get to the heart of each issue individually.  As far as your crowdfunding site question, my inclination is that the IRS would consider this the same as buying a stock or mutual fund as an investment and not being an active trader or real estate investor that would qualify you as being "in business".  

@Nicole Bernshaw - Brandon's email response and @Natalie Kolodij are right on this one without much question.  Education that qualifies you for a new trade or business is non-deductible.  I couldn't deduct my college expense (as a business expense), CPA exam fees or my CPA prep classes as it prepared me for a new career  (pub 970).  Now that I am a practicing CPA, any classes that I take to sharpen those skills are deductible.  Unfortunately that other CPA is wrong.  Unless you were in the real estate world and performing a skill that would be sharpened, there is no way to correctly deduct it under the tax code as written.  So don't bother reading the tax code trying to find that loophole, it won't say anything different.

@Ashish Acharya - That's a doozy of a statement to say that that taxpayer could have used section 195 to capitalize those education expenses as start up costs, even acknowledging it's a risky position.  The IRS has levied penalties on tax preparers who have intentionally and recklessly disregarded the rules in determining a business client's deductions.  The tax case doesn't specifically  address whether the taxpayer could use section 195 on those because it stated that they weren't deductible at all as a business expense as it was determined the classes qualified him for a new trade or business.  

Here's a fancy graph of the timeline of deductibilty and where it falls for those of us who enjoy pictures vs a bunch of dry back and forth between CPAs.

J of A - How to Scale the Wall of Deductibility