Can I deduct this on my tax return?
And who would know if not the almighty IRS? So, let us visit www.IRS.gov and download the official Publication 535 conveniently titled Business Expenses. There, on page 3, we receive the much-appreciated legal guidance:
To be deductible, a business expense must be both ordinary and necessary.
If this is not clear enough, the ever-helpful IRS goes an extra mile to explain what it means:
An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business.
And just in case there is still a trace of uncertainty, the IRS leaves nothing to chance with this last nugget of wisdom:
An expense does not have to be indispensable to be considered necessary.
Maybe it is the fact that English is my second language. Maybe it is something else. Either way, I found the IRS explanation to be quite ordinary, and I felt it was necessary for me to write this article and explain how business deductions actually work. You are welcome.
The upside-down approach is simpler
To start, I suggest that investors change their approach to finding tax deductions. The traditional approach is: give me a complete list of all possible deductions, and I will see which ones I can use. This may work, except that such lists are never totally “complete,” and you still may miss a valuable deduction. Instead of a checklist, go through every single expense you had during last calendar year – using credit card statements, bank statements, computer software, etc. – and pick up every expense that can qualify as deductible business expense.
So, what qualifies as a deductible business expense? Well, like the IRS explained, it should be ordinary and necessary. Just kidding. My highly scientific 4-part test is simply this:
- It had to have business purpose.
- You had to pay for it during last year.
- You could not be reimbursed for this expense.
- It must not be specifically excluded by the IRS.
Now, one part at a time.
1. Was there a business purpose?
If I was a guru, I could have addressed this question with a CD set and a weekend boot camp in Orlando. But since I am no guru, I will simply empower you with this deep question to ask yourself: If I was not running a business, would I have paid for this? If the answer is no - then there was a business purpose.
Let’s practice this test.
- If I was not a real estate investor, would I have paid for the investor club membership? Of course, no. Then the membership fee is a business expense.
- If I was not an investor, would I have purchased attorney Quincy Long’s set of legal forms? Ok, check this for business expense.
- If not an investor, would I have driven to this networking meeting? Then, it is business mileage.
See how it works? And, by the way, good luck finding a “complete list” of deductions that includes items like realty club membership or attorney’s legal forms.
My magic Would you have paid for it..? question applies even to so-called “gray area” situations. Digital camera? Trip to Dallas? Pre-paid Legal? New truck? If you can keep a straight face saying - This was strictly for business – you have a business expense. If you answer – This was kind of a business purchase - then maybe you need to take some percentage of this expense, not the entire amount. Such part-personal/part-business use is typical for automobiles, cell phones, computers, and Internet service.
Finally, try my question on the more “creative” deductions, such as medical bills, groceries, and Christmas gifts. Are you saying that, if not in business, you would still walk around with that toothache, go hungry, and leave your kids without presents? See what I mean? This year, one of my clients brought me a spreadsheet that included (true story!) an expense category Alcohol & Tobacco. I understand that in the current market it may be a necessity for some, but these are still non-deductible personal expenses. Even if they are paid from a business account or charged on a company credit card. Sorry, Mr. Trump, your trademark haircuts are not deductible either.
2. Did you pay for it during last calendar year?
Actually, this is not as simple as it sounds. For the IRS, you can say paid when you either:
- paid by cash
- mailed out a check
- charged your credit card
Note that it does not matter when you pay your credit card bill. Paying credit card bills is between you and VISA. It is a matter of borrowing money, not a matter of purchasing. The moment it is charged, it is considered paid for tax purposes. Yes, if you charged your county and school district property taxes online on December 31st, it does count for last year.
The same principle applies when you put building materials on Home Depot card or buy appliances with “no payments for 12 months” promotions. These purchases count on the day when you signed on the dotted line, not when you repaid what is essentially a loan from Home Depot.
Be careful to not deduct items that you did not pay for. One of the most common mistakes is deducting the cost of your own labor. Yes, if you hired a contractor, you would have paid him. The key word is if. You did not hire that contractor, you did not pay him, and you did not pay yourself. The money is still in your pocket. So, there is no tax deduction, sorry.
Another very common mistake is deducting unpaid rent or vacancy. Why it cannot be deducted? Well, because you did not pay for it. You did not write a check to your tenant for “unpaid rent”, right? No money paid – no deduction. Then how are you compensated for the uncollected rent? Very simple: you simply do not count it as income. Instead of reporting $12,000 rent income for 12 months, you will report only $9,000 income for the 9 months that it was actually rented.
3. Was it reimbursed by somebody?
I always thought that this part was simple. If you bought plane tickets for a business trip, but your employer or your broker reimbursed you later, you did not really pay for it, did you? The money is back in your pocket. Nothing spent – nothing deducted.
Couple more examples.
- If your inkjet printer is free after mail-in rebate – you cannot deduct its cost, because your cost is zero.
- If your closing costs were picked up by the seller – they were not your expenses.
- If your insurance paid for the water damage, you can only count the amount of your deductible (no pun intended). Everything above the deductible came from the insurance company’s pocket – so no tax deduction for you.
4. Was it specifically excluded by the IRS?
Like it or not, but even if you and I agree that something qualifies as a business expense, the IRS has power to veto it. Among the items that the IRS does not allow to deduct:
- all kinds of fines and penalties, such as city fines for code violations and traffic tickets
- clothes that could be worn in non-business setting, including business suites and shoes
- 50% of all business meals and entertainment (except feeding the crews on-site)
- more than $25 per person per year in business gifts
- income taxes (but you can deduct other taxes, such as payroll, franchise, and property taxes)
How can you know all possible IRS gotchas? You probably cannot. To be safe, if you are not sure, put the questionable item on the list (separately of course!) and ask your trusted accountant.
And, speaking of accountants – remember that hiring a tax expert to prepare your tax return professionally will certainly qualify as ordinary and necessary business expense. Even under the ridiculous IRS definition.