Money-Saving Tips for Us All
These recent victories by taxpayers over the IRS highlight tax-saving strategies that you might use to reduce your own taxes…
Get a tax break on your “hobby” expenses. Henry Metz owned and operated a baking business in Sioux City, Iowa, that he sold for a multimillion-dollar gain in 2000, after which he and his wife lived on the income from their investments.
Metz and his wife enjoyed raising Arabian horses and operated a breeding farm, which they moved from near their Sioux City home to Naples, Florida, in 1995, and then to the Santa Ynez Valley in California in 2003. From 1999 to 2009, the farm had losses averaging more than $1 million per year and totaling nearly $15 million, which the Metzes deducted against their overall income.
IRS Objection: Losses so large over so long a time indicated that the Metzes could not possibly have been operating the horse farm with a profit motive—it instead must be just a hobby that they were using as a tax shelter, so their losses were disallowed.
Tax Court Ruling: Many legitimate attempts to start a business never earn a profit, so a string of losses does not prove that a person does not intend to earn a profit. Instead, intent should be judged by how the activity is managed. The Metzes had a business plan that they revised as they gained experience. They kept good books and records, consulted with experts, invested in marketing their business, relocated their farm to improve its financial results and took other steps in an attempt to make it successful. All this indicated the required intent to earn a profit. Their intent may have been unrealistic—but long-shot attempts to start profitable businesses sometimes succeed. Since there was an intent to earn a profit, even though the attempt was unsuccessful, their loss deductions were allowed.
Lesson: A money-losing hobbylike sideline may later turn into a money-maker or even a second career, and you can take deductions for the initial losses, in effect using them as a subsidy for start-up costs, if you intend to make a profit from the activity. This can apply even to activities such as stamp collecting, composing music and auto racing, and you can deduct normal business-related expenses such as auto use, equipment costs, travel, meals and even a home office. But you must demonstrate a profit motive, which establishes the activity as a business, to be able to deduct any loss. The IRS and Tax Court can’t read your mind to judge your intent, so they will judge it by whether you manage your sideline in a fully businesslike manner.
Henry J. Metz, Tax Court Memo 2015-54
A barking dog can create a home office expense. Denise McMillan was self-employed in the information technology business and worked from a home office located in a condominium unit in California that she owned and lived in.
She was unhappy with the condominium’s managing homeowner’s association and filed a lawsuit against it. In the lawsuit, she complained about construction defects that caused mold in her bathroom and noise problems…and dogs running wild, barking and defecating around the property. Complicating matters, she ended up facing criminal misdemeanor charges as a result of her attempts to gain evidence for her lawsuit. The charges were dropped after she paid a total of $26,312 in legal costs, including $5,000 to a lawyer to defend her in the criminal case and $212 in sheriff’s department and court costs. Because she treated half of her apartment as a home office, she deducted half of the $26,312 as a business expense.
IRS Objection: McMillan’s complaints against the homeowner’s association had no relation at all to her information technology business and involved entirely personal matters, so the related legal costs were not deductible.
Tax Court Ruling: The home office is a business property, and the IRS had not explained how the noise and other factors that McMillan had complained of would fail to affect her business use of it. Thus the expenses that she claimed were related to her business and the deductions she claimed were fully allowed—including her criminal defense fees.
Lesson: Having a home office may enable you to claim unexpected deductions for otherwise nondeductible personal home-ownership costs not directly related to your business but related to the part of your home used in the business. You also may be able to deduct a portion of the costs of insurance, maintenance, utilities and rent or depreciation on the home you own.
Denise Celeste McMillan, Tax Court Memo 2015-109
Unmarried individuals can take multiple maximum mortgage deductions on the same home. Bruce Voss and Charles Sophy were unmarried domestic partners living in California. In 2006 and 2007, they jointly owned two homes, using one as a principal residence and the other as a second home. They were jointly liable for each of the two mortgages, which amounted to more than $2 million on the primary residence and $200,000 on the second home. Voss and Sophy each claimed deductions on interest for the maximum allowable mortgage amounts—$1 million on a mortgage for a principal residence plus $100,000 of home-equity borrowing, for a total of $2.2 million in mortgages.
IRS Objection: The deduction limit should be applied per residence, not per individual, so the deductions should be cut in half.
Tax Court Ruling: The Tax Court upheld the IRS interpretation of the law.
US Court of Appeals Ruling: The law allows the maximum deduction on a per-taxpayer basis, which means that multiples of the maximum mortgage deduction can be claimed on a single residence by unmarried separate taxpayers who jointly own it. However, married individuals are treated as a single taxpayer subject to the $1.1 million limit (or $550,000 for each spouse filing a separate return).
Lesson: There is no limit on the number of maximum mortgage interest deductions that can be claimed on a single home as long as the owners are not a married couple. If family members (other than a married couple), friends or even strangers buy a home, whether it is a primary residence or vacation home, that expands the overall allowable deduction amount.
Bruce H. Voss, US Court of Appeals for the Ninth Circuit, No. 12-73257
You might get a tax break on a home you don’t own. Qui Van Phan wanted to buy his family’s three-acre California ranch from his parents in 2010 when they got a divorce, but he could not afford to buy the property and could not obtain a mortgage on it. However, to obtain the home, he promised his parents and siblings that he would pay the existing mortgage and property taxes on it and act in all ways as the owner. He began doing so, and for the 2010 tax year, he deducted $35,880 of mortgage interest.
IRS Objection: The mortgage-interest deduction is disallowed because Van Phan’s name was not on either the title to the home or the mortgage.
Tax Court Ruling: Van Phan had lived in the home and acted as the actual owner of it in all ways. He had paid for the insurance, utilities and other such costs, maintained the property and made improvements to it. The genuineness of the arrangement was confirmed by his obtaining title to the home three years later. Thus he met the tests of “equitable” ownership by assuming all the costs and obligations of ownership even though he lacked legal title. That means he was entitled to the deduction.
Lesson: Inability to obtain a mortgage may be a problem when someone is seeking to buy a home or when a house is being transferred among family members or through a divorce. In that case, the person acquiring the home can use equitable ownership to be able to deduct interest on the existing mortgage on the house by acting in all ways as the real new owner of the property. The IRS is likely to be suspicious of such an arrangement, though, so protect it with a written promise to assume all ownership obligations and by keeping good records showing that you actually have done so. Although not addressed in this ruling, home transfers between unrelated parties also can use equitable ownership to transfer deductions when the recipient of the home is unable to finance legal ownership and a new mortgage.
Qui Van Phan, Tax Court Summary Opinion 2015-1