Do any of your clients own big-ticket personal items like boats and private planes? Besides the personal pleasure, a taxpayer may try to some tax benefits by using boats and planes in business activities. But that’s when the “hobby loss rules” often come into play.
Two new cases are prime examples. In the first, Steiner, TC Memo 2019-25, 4/2/19, a couple charted out a yacht they owned. In the second, Kurdzeil, TC Memo 2019-20, 3/21/19, the taxpayer claimed deductions for leasing his antique plane. Neither argument flew very far with the Tax Court.
Generally, you can fully deduct expenses from a legitimate business, but deductible expenses are limited to the amount of income if an activity is treated as a hobby. Furthermore, under the new Tax Cuts and Jobs Act (TCJA), you currently can’t claim any hobby expense deductions, because these expenses were claimed as miscellaneous expenses. The TCJA eliminates the miscellaneous expense deduction for 2018 through 2025.
To qualify as a business and not a hobby, a taxpayer must operate in a business-like fashion with intent to turn a profit. The courts rely on the following nine factors for this determination:
- The manner in which the taxpayer carries on the activity;
- The expertise of the taxpayer or his or her advisers;
- The time and effort expended by the taxpayer in carrying on the activity;
- The expectation that the assets used in the activity may appreciate in value;
- The taxpayer’s success in carrying on other similar or dissimilar activities;
- The taxpayer’s history of income or losses with respect to the activity;
- The amount of occasional profits, if any, which are earned;
- The financial status of the taxpayer; and
- Any elements indicating personal pleasure or recreation.
No single factor controls. The outcome is based on all the relevant facts and circumstances.
Case #1: A couple bought a 155-foot yacht in 2001 for about $4.6 million. It had a full-time captain and crew. The taxpayers renovated it between 2006 and 2009 at a cost of approximately $10.8 million. Until 2009, the yacht was used for strictly personal purposes.
The couple then entered into chartering activities about the same time they intended to sell the yacht. In 2011, the gross chartering receipts of $164,700 were reduced by $113,700 for cost of goods sold. Also, the couple deducted $757,000 in expenses. For 2012, the year the yacht was sold, it generated no income, but expenses totaled $122,000.
In examining the nine factors, the Tax Court found that only one weighed in the couple’s favor. Ironically, it was the one about elements of pleasure or recreation. The other eight factors weighed against the taxpayers. Accordingly, the losses were denied.
Case #2: The taxpayer, a former Navy pilot, bought an antique World War II fighter plane for $200,000 in 1983. It wasn’t operational. He then spent years and a significant, but undisclosed, amount of money restoring it.
Between 2002 and 2012, the taxpayer was well known for participating in the airshow circuit as “Captain Eddie.” However, he had to stop in June 2012 due to a botched landing in which he was unhurt.
From 2007 through 2010, the taxpayer reported his airplane activity as an airplane leasing business. For the first three years, he showed income of $10,000, $14,000 and $14,000, and then zero income for 2010. Yet he also reported net annual losses between $117,000 to $130,000, mostly from depreciation. During the tax years in question, he earned about $180,000 a year as a pilot.
But the IRS denied the losses. The taxpayer’s argument was hurt by discrepancies in his story about the rental activities. Nor did he ever demonstrate a bona fide profit motive based on the factors. Ultimately, the Tax Court sided with the IRS.
Moral of the story: Instruct clients to protect deductions for business activities based on the nine controlling factors. Due to the changes in the TCJA, there’s even more at stake tax-wise this year.