Unlike property that is held as an investment or as part of a trade or businesses there is no specific authority for deducting management and operating expenses associated with property that is held as a hobby or for personal use.
Section 183 of the Internal Revenue Code states that an activity not engaged in for profit is any activity other than one for which deductions are allowable under Section 162 (Business expenses) or Section 212 (investment expenses).
Who is affected by Section 183
Section 183 expressly applies only to activities engaged inby individuals and S corporations. However, the regulations provide that,because the taxable income of an estate or trust is computed in essentially thesame manner as that of an individual, Section 183 applies in computing theallowable deductions of an estate or trust.
General Guidelines for Hobby/Personal Use Expenses
If you are not holding the property for the production ofincome as a business or investment, you may be able to deduct some of youroperating expenses under the provisions of the "Hobby Loss Rules"(Section 183).
The "Hobby-Loss Rules" state that if an activity,either a business or investment, generates a profit in 3 out of 5 consecutiveyears the IRS will assume that you are engaged in the activity with the intentto make a profit. The IRS can however, question the validity of thespecific expenses you are claiming.
If you did not make a profit in 3 out of the last 5 years the IRS will notautomatically assume that you are not engaged in the activity with the intentionof making a profit. In the absence of proof, the burden is on you to proveby a showing of the facts for your particular circ*mstances that you intend tomake a profit and have a reasonable expectation of eventually being able to doso.
In determining whether an activity is engaged in for profit,greater weight is given to objective facts than to the taxpayer's mere statementof their intent. Some of the relevant factors that the IRS will look atwhen determining if an activity is engaged in for profit are:
- Manner in which the taxpayer carries on the activity
- The expertise of the taxpayer or his advisors
- The time and effort expended by the taxpayer in carrying on the activity
- Expectation that assets used in activity may appreciate in value
- The success of the taxpayer in carrying on other similar or dissimilar activities.
- The taxpayer's history of income or losses with respect to the activity
- The cause of the losses
- The amount of occasional profits, if any, which are earned
- The financial status of the taxpayer
- Elements of personal pleasure or recreation
- Expectation of profit by the taxpayer
No one factor is determinative in making this determination. It is not intended that only the factors described above are to be takeninto account in making the determination, or that a determination is to be madeon the basis that the number of factors indicating a lack of profit objectivesexceeds the number of factors indicating a profit objective, or vice versa.
Profit for purposes of the Hobby-Loss Rule is the amount bywhich revenue from the activity exceeds the costs incurred to realize therevenue. In the case of timber production the revenue considered includesthat from the sale of stumpage, from the sale of products cut from the timber,and potential gains on the land itself. If profitability depends upon returns from the disposal of land you need to make clear that you are treating the land as part of the timber production activity, and not as a separate activity.
WARNING: IRS Has increased It's Focus on Hobby Loss Rule
The IRS has for several years used fact sheets to bring to the attention of taxpayers areas of concern. The latest one, FS-2007-18 , "Business or Hobby? Answer Has Implications for Deductions," summarizes the so-called hobby loss rule, lists the factors used to determine when an activity is engaged in as a for-profit business or as a business. It also summarizes how expenses are treated when an activity is a hobby. There is no indication that the IRS is focusing on forest owners or timber producers, but they have a special burden to prove that they are engaged in the activity for profit since most can't meet the 3 out of 5 year presumptive test.
How do you determine what is deductible?
Deductions under Section 183 are limited to the amount ofincome generated from the property during the year. In other words "hobby" deductions cannot exceed "hobby" income for theyear.If an activity is not engaged in for profit, deductions are allowable in thefollowing order and only to the following extent.
First expenses that could be deducted without regard to the profit motive, such as interest expenses, and taxes are deducted
Expenses related to the hobby that would be deductible if the hobby had been characterized as "for profit", either as a business or investment are deducted and,
Deductions for such items as depreciation, partial losses with respect to property, and amortization
Expenses in excess of income are considered hobby losses and are not deductible.
If there was no income generated from the property during theyear in which expenses were incurred then the management and operating expensesmust be capitalized for recovery later through depreciation, amortization,allowable basis, depletion, or by sale or other disposal of the property.
What are Carrying Charges?
If you prefer, an election to capitalize certain tax expenses can be made by treating the expense as a "carrying charge." These tax expenses would then be recovered upon sale of the timber rather than deducting them the year in which they where incurred. Severance and yield taxes may not be capitalized and must be deducted in the year in which they are incurred.
