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Expenses for Lawsuit against Condo Homeowner's Association Are Partially Deductible.

(Parker Tax Publishing June 25, 2015)

A condo owner was allowed to deduct on her Schedule C a percentage of legal fees incurred to sue her homeowner's association because of unruly dogs in the building, mold in her bathroom, and noise problems; and, because the IRS failed to prove that interest expense relating to her equine activity was not an expense incurred in a trade or business, that amount was deductible as well. McMillan v. Comm'r, T.C. Memo. 2015-109.

Background

Denise McMillan lives in a condo unit in which she maintains a home office where she works in the information technology and database management field (IT activity). A homeowners association (HOA) has various duties and responsibilities with respect to the condo unit. In 2005, McMillan filed a lawsuit against the HOA and various unnamed persons in which she complained of: (1) dogs running wild, dogs barking, and dogs defecating around the property; (2) construction defects related to the presence of mold in her bathroom; and (3) construction defects that caused noise problems. The HOA litigation was settled in June 2010.

In 2009, in connection with the HOA litigation, McMillan was involved in a separate legal action involving misdemeanor criminal charges connected with her attempt to gather evidence for the HOA litigation. She incurred legal expenses of $26,312 in 2009 in connection with both the HOA litigation and the separate legal action.

McMillan also incurred expenses in 2009 relating to an equine activity. She testified that she is an international dressage rider and trainer and that, in 2009, she trained horses, although a moving company had lost her records documenting that activity. From 1999 through January 2008, McMillan owned a horse named Goldrush. From at least 1999 through 2009, McMillan did not compete in any horse shows with Goldrush or any other horse. McMillan was unsuccessful in breeding Goldrush and, as a result decided to send him to Australia in the hope that his breed and bloodline would make him an attractive breeding stallion there. However, in January 2008, after Goldrush arrived in Australia, he became unexpectedly ill and died. From 2004 through 2009, McMillian included as part of her tax return a Schedule C for the equine activity. She reported expenses but no net income from the activity in those years and only reported receipts in 2004.

With her 2009 tax return, McMillan filed two Schedules C, and a Form 8829, Expenses for Business Use of Your Home. On the Schedule C relating to her IT activity, McMillan took a deduction of $26,312 for legal expenses relating to the HOA litigation. The Form 8829 reported 50 percent as the business use percentage for McMillan's business use of her home. On the Schedule C relating to her equine activity, McMillan reported zero receipts and expenses of $7,486. Of that amount, $5,690 was interest expense related to indebtedness McMillan incurred in 2007 to transport Goldrush to Australia.

The IRS disallowed the legal expenses and the equine activity deductions. With respect to the legal expenses, the IRS argued that the expenses were not related to McMillan's IT activity and were personal nondeductible expenses. With respect to the equine activity, the IRS said the expenses should be disallowed for two reasons: (1) the equine activity was not a going concern and McMillan was therefore not carrying on a trade or business, and (2) the equine activity was not an activity engaged in for profit within the meaning of Code Sec. 183.

Analysis

The Tax Court held that McMillan could deduct 50 percent of the legal expenses and the interest expense of $5,690 on the equine activity debt. The Tax Court noted that the dispute giving rise to the legal expenses arose principally on account of McMillan's claims of noise and other factors interfering with her use and enjoyment of her condo. While such expenses would generally not be deductible as ordinary and necessary business expenses, the court concluded that, because McMillan reported a 50 percent business use of the condo unit, she was entitled to deduct 50 percent of the legal expenses. The IRS, the court said, failed to prove that McMillan used any lesser percentage of the unit for business or that the complained-of noise and other factors did not affect her business use of the unit.

On the basis of McMillan's history of substantial losses in her equine activity from 2004 through 2009, the court found that, during 2009, she did not carry on the equine activity to make a profit. Thus, the court sustained the IRS's disallowance of deductions for all of the equine activity expenses other than the $5,690 interest expense. With respect to the interest expense, the court held that the IRS failed to show that the interest was not deductible irrespective of whether, in 2009, the equine activity was engaged in for profit. While Code Sec. 163(h) disallows an interest deduction for personal interest, the court observed, interest paid or accrued on indebtedness properly allocable to a trade or business generally is not personal interest. In general, the court noted, interest expense on a debt is allocated in the same manner as the debt to which the interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures and in the instant case, the court stated, the debt financed expenditure was for the transport of Goldrush to Australia in 2007.

The court held that McMillan could deduct the interest expense because the IRS failed to prove that the equine activity was not a trade or business in 2007 or that, even if it was, it was not an activity engaged in for profit in 2007. The court concluded that the interest expense was deductible because the IRS failed to prove that the debt-financed expenditure to transport Goldrush to Australia in 2007 was not a trade or business expenditure in an activity engaged in for profit.

For a discussion of the deductibility of legal expenses, see Parker Tax ¶90,150. For a discussion of interest allocation rules, see Parker Tax ¶83,580. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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