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Deductions: Buying or Starting a Real Estate Business
By Robert Klein, CPA
An investor is considering whether to buy an apartment building. Another one is thinking about
buying shares in a real estate limited partnership (RELP). A third wants to expand his real estate
holdings. In each case, how are the investigatory or start-up costs to be treated for tax purposes?
Must they be capitalized and, so, not recouped until the activity is sold or terminated? Or can they
be amortized over 60 months as permitted by Code Section 195? And what constitutes investigatory and
start-up costs? Even though Section 195 was put into the tax code in 1980 (and amended in 1984),
answers to these questions are still not clear. The discussion that follows seeks to clarify the
current consensus.
Trade or Business Requirement
Section 195 permits a 60-month write-off of start-up costs only if they are related to the
investigation or creation of an active “trade or business” (TOB). At the outset, this requirement
precludes deduction of costs attributable to an “investment.” Operating income-producing real estate
is generally considered to be an active TOB. The Senate Finance Committee Report in 1980 stated that
“In the case of rental activities, there must be significant furnishing of services incident to the
rentals to constitute an active business ... Thus, a rental activity is not considered to be an
active trade or business solely because deductions attributable to it are allowable in computing
adjusted gross income ... In general, the operation of an apartment complex, an office building or a
shopping center would constitute an active trade or business.”
Taxpayer's Role in Business
In addition to the activity being an active TOB, the taxpayer must have an equity interest in the
activity and participate in its management. A sole proprietor is always regarded as having the
requisite equity interest, but a taxpayer whose interest is represented by debt, preferred stock or
a limited partnership interest would not qualify. A general partner will have an active interest if
the partner actively participates in management.
Start-up Costs Defined
Start-up costs are defined in Section 195 as any amount paid in connection with:
- investigating the creation or acquisition of a TOB;
- creating an active TOB; or
- engaging in a profit-seeking activity anticipated to become a TOB.
In addition to being one of the foregoing, an amount is a start-up cost only if it would have
been deductible by an existing TOB. Thus, costs that would be capitalized in any event cannot become
start-up costs. Finally, start-up expenses do not include payments for interest, taxes or the actual
cost of acquiring a TOB.
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Two Types of Start-up Costs
The committee reports in connection with the 1980 legislation indicated that amortizable start-up
costs are of two kinds: investigatory and pre-opening. Eligible investigatory costs are those
incurred in reviewing a prospective business prior to reaching a final decision to acquire or enter
the business. Such costs include those for analyzing or surveying potential markets, labor supplies
and transportation facilities. Eligible start-up costs are those incurred subsequent to the decision
to enter or establish a particular business, and which are incurred prior to the date on which the
business begins. Such costs might include those for advertising; compensation to employees being
trained; travel and other expenses incurred in finding customers or tenants; and salary and fees
paid to executives, consultants and professionals.
On the other hand, costs to actually acquire a specific business are capital in nature and must be
capitalized pursuant to Code Section 263. Such costs include legal fees for preparing regulatory
approval documents and due diligence to review the books and records of the business to be acquired.
In Revenue Ruling 99-23 (as amended by Announcement 99-89), the IRS established a “bright line
rule” for deciding whether or not a cost is a start-up expense. In general, this rule further
clarifies the distinction just made. Expenses in the course of generally searching for or
investigating a TOB include those to determine (1) whether to enter a new business, and (2) which
new business holds investigatory costs that are start-up expenses under Section 195). By contrast,
once the “whether and which” decisions are made, costs to acquire a specific business are capital in
nature. The IRS will apply a facts and circumstances test to determine whether an expense
facilitates the “whether and which” decisions or is an acquisition cost.
In connection with real estate investments, eligible start-up expenses probably include the
following: (1) travel expenses to view a proposed site or building; (2) fifty percent of otherwise
eligible meal and entertainment expenses, such as meals during travel, business meals, and meals and
entertainment preceding or following a substantial and bona fide business discussion; and (3) fees
paid to a market research firm to analyze the demographics, traffic patterns and general economic
conditions of a neighborhood.
Diversifying a Trade or Business
An existing TOB that diversifies normally will treat any related costs as ordinary and necessary
business expenses (except obvious capital costs for acquiring building and equipment). In some
situations, the IRS could claim that the expansion actually amounts to acquiring a new TOB and,
thus, start-up costs must be amortizable or capitalized, but cannot be, in any event, immediately
deductible. In the case of real estate, each individual property usually has been considered a
separate TOB. As a result, it appears that the acquisition of new properties will be considered as
the acquisition of a new TOB, subject to the rules under Section 195. However, there do not seem to
be any rulings on this point.
Robert Klein, CPA, is a Tax partner in our Woodbridge, New Jersey office. He can be reached at (732) 750-0900.
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