Miscellaneous Itemized Deductions-Suspended

Take-Away: We sometimes forget that miscellaneous itemized tax deductions are suspended until 2026.

Background: The 2017 Tax Act provided many favorable provisions for individuals, including the lowering of the highest federal income tax rate ( to 37%), limiting the number of tax brackets; a broadening of the marginal federal income tax brackets, the doubling of the standard deduction, the doubling the federal transfer tax applicable exemption amount, etc. However, the same Tax Act also curtailed some other favorable opportunities under the Tax Code, such as limiting the state and local tax (SALT) itemized deduction to $10,000 a year. One other opportunity that was suspended from 2018 through 2025, when the sun sets, was the Tax Code’s miscellaneous itemized deduction rule.

Hobby Loss Rule: The Tax Code limits the ability to deduct expenses that are associated with activities “not engaged in for profit.” [IRC 183, often referred to as the hobby loss rules.] Common business activities that tend to fall into the hobby-loss category are cattle, horses (breeding and racing), aircraft (leasing and chartering), yachts (chartering), boats (tours and guides), hunting and fishing (lodges and guides), rental real estate, (e.g. VRBO),  woodworking, photography, Christmas trees, cannabis, and farming, (e.g. vineyards.) The expenses that are associated with these activities often fall into the category of miscellaneous itemized deductions. IRC 183 limits the losses that can be sued to offset other income from other activities. IRC curtails those deductions when the activity is deemed a hobby. An activity not engaged in for profit is any activity other than those that would have expenses allowed as a ‘trade or business’ defined in IRC 162 or as an ‘investment’ defined under IRC 212. [IRC 183(c).] There is a presumption that the activity is ‘for profit’ under IRC 183(d) using the ‘three out of five year’ rule. Gross income from the activity must exceed deductions from the activity in three out of the previous five years. If it does then the activity is likely presumed to be an activity that is engaged in for profit. Thus, a taxpayer must show a ‘primary, predominant, or principal purpose of creating a profit.’ [Prieto v. Commissioner, Tax Court Memo, 2001-266.]

Miscellaneous Itemized Deductions: Itemized deductions, generally, are those deductions that are not associated with a business activity or the production of income. Unless the itemized deduction in question falls into one of twelve (12) specifically enumerated categories, e.g., interest, taxes, charitable contributions, medical expenses, they are all treated as miscellaneous itemized deductions. As an even broader generalization, miscellaneous itemized deductions are deductible only to the extent that they exceed 2% of the individual taxpayer’s adjusted gross income.

2017 Tax Act ‘Suspension:’ The 2017 Tax Act provides that between 2018 and 2025, an individual taxpayer who earns $300,000 gross income and incurs $300,000 expenses in a business activity that is ultimately determined to be a hobby under IRC 183 must report all of the $300,000 of gross income and deduct virtually none of the $300,000 of expenses. This suspension, and the hardship its causes, was recently the subject of a Federal Court decision.

Gregory v. Commissioner, (B.L. 11^th Circuit 2023, Tax Court Memo 2021-115, September 29, 2021)

Facts: Mr. Gregory conducted a charter boat operation, and for the tax years in question he reported gross income of $300,000 from his charter boat operation, and deductions of slightly more than $300,000 that were attributable to the charter boat operation. Mr. Gregory later conceded that his charter boat operation was a hobby, but he then argued in the Tax Court that to the extent the deductions offset his gross income (i.e., they did not create a loss for income tax reporting purposes) the deductions should be fully allowed and claimed by him.

Tax Court: The judge held that other than deductions that are allowed whether or not an activity is engaged in for profit, e.g., interest expenses, real and personal property taxes, all of the deductions that were associated with Mr. Gregory’s charter board operation should be treated as itemized deductions, and more specifically miscellaneous itemized deductions. And since Congress entirely suspended the income tax deduction for miscellaneous itemized deductions for 2018 through 2025, no deductions could be claimed by Mr. Gregory to offset the $300,000 of income that he earned from his charter boat activity.

Appeals Court: The Tax Court judge’s decision was affirmed on appeal in light of Mr. Gregory’s concession that his charter boat activities were, in fact, a hobby and because the Tax Code is clear that all miscellaneous itemized deductions otherwise available to Mr. Gregory are suspended through 2025.

Recharacterization as a Hobby: The Gregory case illustrates the importance of establishing a for-profit motive for business activities that are otherwise vulnerable to recharacterization as a hobby under IRC 183. The initial analysis by the IRS (and the Courts) will be a scrutiny of the historical profits and losses associated with the activity, noting that losses during the start-up phase of the activity are not fatal, and the appreciation of some of the activity’s assets may overcome a history of losses.

Regulations: The Regulations that implement IRC 183 identify several factors that courts must look at to determine whether an activity is engaged in for profit instead of for recreational or for personal enjoyment purposes. Some of the factors highlighted in the Regulations focus on whether the activity was carried on in a business-like manner include: (i) the use of a written business plan; (ii)  maintaining accurate business records and books; (iii) the use of a separate bank account; (iv) adherence to the legal formalities of the entity that conducts the business; (v)adaptations that were made to make the activity profitable; (vi) the owner’s own business expertise; and (vii) the use of a business consultant.

Conclusion: In light of the outcome in the Gregory case and the current prohibition on the deduction of miscellaneous itemized deductions some of our clients may be vulnerable to having their ‘business activity’ recharacterized as an IRC 183 hobby. In these situations, the client should do everything possible to document their for-profit motive, literally each month, and not be casual in how they document their income and expenses. While these records may look like window-dressing, they may prove to be critical if the activity is one that could be considered as recreational or for personal enjoyment.