Page 8

Example 2. You are a cash method calen- dar year taxpayer. On December 1, 2018, you sign a 12-month lease, effective beginning Jan- uary 1, 2019, and immediately pay your rent for the entire 12-month period that begins on Janu- ary 1, 2019. The right or benefit attributable to the payment neither extends more than 12 months beyond January 1, 2019 (the first day that you are entitled to use the property) nor be- yond the tax year ending December 31, 2019 (the year following the year in which you made the advance payment). Therefore, your prepay- ment does not have to be capitalized, and you can deduct the entire payment in the year you pay it. Contested liability. Under the cash method, you can deduct a contested liability only in the year you pay the liability. Under the accrual method, you can deduct contested liabilities such as taxes (except foreign or U.S. posses- sion income, war profits, and excess profits taxes) either in the tax year you pay the liability (or transfer money or other property to satisfy the obligation) or in the tax year you settle the contest. However, to take the deduction in the year of payment or transfer, you must meet cer- tain conditions. See Regulations section 1.461-2. Related person. Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not yet paid them. However, if you and the person you owe are related and that person uses the cash method of accounting, you must pay the ex- pense before you can deduct it. Your deduction is allowed when the amount is includible in in- come by the related cash method payee. For more information, see Related Persons in Pub. 538. Not-for-Profit Activities If you do not carry on your business or invest- ment activity to make a profit, you cannot use a loss from the activity to offset other income. Ac- tivities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations. In determining whether you are carrying on an activity for profit, several factors are taken into account. No one factor alone is decisive. Among the factors to consider are whether: • You carry on the activity in a businesslike manner, • The time and effort you put into the activity indicate you intend to make it profitable, • You depend on the income for your liveli- hood, • Your losses are due to circumstances be- yond your control (or are normal in the start-up phase of your type of business), • You change your methods of operation in an attempt to improve profitability, • You (or your advisors) have the knowledge needed to carry on the activity as a suc- cessful business, • You were successful in making a profit in similar activities in the past, • The activity makes a profit in some years, and • You can expect to make a future profit from the appreciation of the assets used in the activity. Presumption of profit. An activity is pre- sumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they pro- duced a profit in at least 2 of the last 7 tax years, including the current year. The activity must be substantially the same for each year within this period. You have a profit when the gross income from an activity exceeds the de- ductions. If a taxpayer dies before the end of the 5-year (or 7-year) period, the “test” period ends on the date of the taxpayer's death. If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried on for profit. This means the limits discussed here will not apply. You can take all your business deductions from the activity, even for the years that you have a loss. You can rely on this presumption unless the IRS later shows it to be invalid. Using the presumption later. If you are start- ing an activity and do not have 3 (or 2) years showing a profit, you can elect to have the pre- sumption made after you have the 5 (or 7) years of experience allowed by the test. You can elect to do this by filing Form 5213. Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity. The benefit gained by making this election is that the IRS will not immediately question whether your activity is engaged in for profit. Accordingly, it will not restrict your deductions. Rather, you will gain time to earn a profit in the required number of years. If you show 3 (or 2) years of profit at the end of this period, your de- ductions are not limited under these rules. If you do not have 3 (or 2) years of profit, the limit can be applied retroactively to any year with a loss in the 5-year (or 7-year) period. Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the tax return for the last year of the period. The period is extended only for deductions of the activity and any related deductions that might be affected. You must file Form 5213 within 3 years after the due date of your tax return (determined without extensions) for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the IRS proposing to disallow de- ductions attributable to the activity. Gross Income Gross income from a not-for-profit activity in- cludes the total of all gains from the sale, TIP exchange, or other disposition of property, and all other gross receipts derived from the activity. Gross income from the activity also includes capital gains and rents received for the use of property that is held in connection with the ac- tivity. You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts. However, if you determine gross income by subtracting cost of goods sold from gross receipts, you must do so consistently, and in a manner that follows generally accepted methods of account- ing. Limit on Deductions You can no longer claim any miscella- neous itemized deductions. Miscella- neous itemized deductions are those deductions that would have been subject to the 2%-of-adjusted-gross-income limitation. You can still claim certain expenses as itemized de- ductions on Schedule A (Form 1040). Deductions you can take for personal as well as for business activities are allowed in full. For in- dividuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, may also be deducted. Deduct them on the appropriate lines of Schedule A (Form 1040). For the limits that apply to home mortgage interest, see Pub. 936. Generally, you can deduct a casualty loss on property you own for personal use only to the extent each casualty loss is more than $100, and the total of all casualty losses ex- ceeds 10% of your adjusted gross income (AGI). See Pub. 547 for more information on casualty losses. Disaster tax relief. For personal casualty losses resulting from federally declared disas- ters that occurred before 2018, you may be en- titled to disaster tax relief. As a result, you may be required to figure your casualty loss differ- ently. Beginning in 2018, casualty and theft loss are allowed only to the extent it is attributable to a federally declared disaster. For more informa- tion, see Pub. 976, Disaster Relief. Partnerships and S corporations. If a part- nership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. They are re- flected in the individual shareholder's or part- ner's distributive shares. More than one activity. If you have several undertakings, each may be a separate activity or several undertakings may be combined. The following are the most significant facts and cir- cumstances in making this determination. • The degree of organizational and eco- nomic interrelationship of various under- takings. • The business purpose that is (or might be) served by carrying on the various under- takings separately or together in a busi- ness or investment setting. • The similarity of the undertakings. CAUTION ! Chapter 1 Deducting Business Expenses Page 7