Happy New Year from Dan Johnson, CPA!

As we gear up for next tax season, we find it is a good time to revisit several tax rules that can affect business owners and self-employed individuals. These concepts, when not properly understood, can significantly impact deductions, reported income, and dealings with the IRS.

In this edition, we cover three commonly misunderstood areas of tax law: the Cohan Rule, the Hobby Loss Rules, and the Real Estate Professional Rules. Each play an important role in determining whether expenses and losses are deductible. Even if these topics do not seem immediately relevant, understanding how they work can help you make better recordkeeping decisions and avoid unexpected tax consequences.

The Cohan Rule

What is it?

The Cohan Rule comes from a court case that allows taxpayers to claim certain business deductions even when documentation may be missing. These deductions must be substantiated by expenses that clearly occurred and amounts that can be reasonably estimated.

What does this mean to me?

This rule can be helpful if records were lost, incomplete, or simply not maintained. However, it is important to recognize that nothing is guaranteed, and this is not a substitute for good recordkeeping as it does not apply to all expenses.

Example:A self-employed business consultant may not have receipts for his phone bill, but since it is necessary for his line of work, the Cohan Rule kicks in. The IRS may allow a reasonable estimate of those expenses under the rule, but only if the expense being claimed or estimated is defensible.

Hobby Loss Rules

What is it?

There is a general presumption that anyone carrying on a business activity intends to make a profit. However, if an activity seems to not be engaged in for profit, then the IRS may classify it as a hobby depending on the facts and circumstances. In other words, what is your objective? Thus, we know, no deductions are allowed for expenses incurred in connection with activities that are not engaged in for profit. Hobby loss rules determine whether an activity is considered a legitimate business where profits are added to income and losses are allowed to offset income.

What does this mean to me?

If the IRS reclassifies your business activity as a hobby, deductions may become severely limited, and the IRS may even require an adjustment on prior tax returns.

The IRS makes a decision based on nine key factors that help classify your business as legitimate or just a hobby:

1. In what way is your activity conducted?
   • Businesses generally keep their books, records, and receipts maintained in a professional manner.
2. Expertise of the taxpayer or advisors
   • Businesses should have a keen understanding of their particular industry or have consulted professionals.
3. Time and effort devoted to the activity
   • A significant time investment, especially during years of recorded losses, supports a profit motive.
4. Expectation that assets may appreciate
   • Even if current income is low, future appreciation may indicate a profit intent.
5. Success in similar or past activities
   • A history of turning unprofitable ventures into profitable ones helps your case.
6. History of income or losses
   • Repeated losses may raise scrutiny unless there is a clear explanation.
7. Profit presumption rule
   • Showing a profit in three out of five consecutive years creates a presumption that the activity is for profit.
8. Financial status of the taxpayer
   • If losses significantly reduce other income, the IRS may look more closely.
9. Personal pleasure or recreation
   • Activities with strong recreational elements face higher scrutiny.

Example:

A taxpayer runs a photography activity at a loss while also enjoying it personally. If they maintain formal records, advertise, seek paying clients, and adjust pricing to improve profitability, the activity is far more likely to be treated as a business.
 

Real Estate Professional Rules

What is it?

The IRS generally treats rental real estate as a passive activity, meaning losses are limited and cannot always offset other income. However, taxpayers who qualify as real estate professionals may be able to deduct rental losses currently rather than carrying them forward.

To qualify, both of the following tests must be met each year:

1. More than 50% of personal services must be performed in real property trades or businesses.
2. More than 750 hours must be spent annually in those real estate activities.

What does this mean to me?

Failing either test means rental losses may be limited. This commonly impacts landlords, short term rental owners, and real estate investors with outside employment.

Example:

A taxpayer spends a significant amount of time overseeing his rental properties but also works full-time at his barber shop. Without documentation showing that real estate activities exceed both the 50% and 750-hour thresholds, his rental losses may be limited.
As the year comes to a close, we want to sincerely thank you for your trust, collaboration, and continued partnership.

Working with you this year has been a pleasure, and we truly appreciate the opportunity to support your goals. Your confidence in us means a great deal, and we do not take it for granted.

We look forward to continuing our work together in the year ahead and wish you a successful, healthy, and prosperous New Year.