Real Estsate Construction Delays Kill Tax Deductions – Houston Tax Attorneys

Real estate investors regularly pursue new ventures that require substantial upfront investments before generating any revenue. A successful investor might purchase land for a luxury resort, spend hundreds of thousands on architectural plans and permits, and begin construction on facilities designed to serve paying customers. These early expenditures represent legitimate business development costs, incurred with the genuine expectation of future profits.

But what happens to these costs when construction defects or other problems prevent these ventures from ever opening their doors? Can expenses incurred in planning and developing be deducted as trade or business losses? The answer depends on whether the taxpayer was actually “engaged in carrying on any trade or business” when the losses occurred.

The recent Root v. Commissioner, T.C. Memo. 2025-51, case addresses when ambitious real estate projects fail before operations begin.

Facts & Procedural History

The taxpayers selling their family business in 2008. Prior to this, during the 1990s, while still running their business, the taxpayers began planning their next venture: a recreational ranch and guest lodge in Oregon.

The planned lodge would combine fishing with equestrian activities and hospitality. Beginning in 1995, the taxpayers purchased four parcels of land totaling over 90 acres, including waterways, pasture, and farmland. They invested in property improvements, including waterway restoration to enhance fishing opportunities.

In September 2000, the taxpayers contracted with an architect to design a lodge, guest wing, council house, and barn. Construction began in 2003. The scope of work included the main house, council house, and garage, with the total project representing a substantial investment in what was intended to become a commercial hospitality operation.

Problems emerged almost immediately after the lodge received its certificate of completion in May 2006. Snow and rain caused flooding, revealing serious defects in windows, roofing, and weatherproofing. By 2007, the taxpayers discovered hundreds of bats living in the walls along with rats and mice, creating foul odors throughout the structure. A forensic architect later determined that the foundation was defective and the main fireplace was structurally unsound.

County officials condemned the lodge as unsuitable for occupancy in 2010 after receiving reports of the structural defects. The lodge was eventually demolished. The taxpayers sued their contractor and architect to recover their losses. They ultimately recovered approximately $3 million through arbitration and litigation but paid approximately $4 million in legal fees.

Throughout this entire period

Throughout this entire period, the lodge never hosted overnight guests. The taxpayers never obtained an innkeeper’s license, hired hospitality employees, or developed booking systems. While they did host occasional events on the property between 2002 and 2009–including television filming, fundraisers, and dog trials–none involved stays at the lodge.

The taxpayers initially filed their 2014 tax return listi…

The taxpayers initially filed their 2014 tax return listing the husband’s principal business as a consulting business reporting more than $300,000 in gross receipts. However, in May 2018, they filed an amended return claiming a $5 million dollar loss related to the lodge project. They carried portions of this claimed net operating loss to their 2017 and 2018 returns, claiming carryovers of $3 million each year. The IRS examined the tax returns and issued a IRS Notice of Deficiency disallowing the net operating loss carryovers in full and imposing accuracy-related penalties for both years.

Trade or Business Requirements Under Section 165

Section 165(c)(1) allows individual taxpayers to deduct losses “incurred in a trade or business.” This requires the taxpayer actually be engaged in a trade or business when the loss occurs. This is different than the rules under subsection (2), which does not have a trade or business requirement.

The distinction between business losses under Section 165(c)(1) and investment losses under Section 165(c)(2) has significant implications for tax treatment and carryover rules. Business losses (under subsection (1)) can generate net operating losses that may be carried back or forward to offset income in other years, while investment losses (under subsection (2)) are generally limited to offsetting capital gains and may be subject to different timing restrictions. Additionally, business losses (under subsection (1)) aren’t subject to the investment interest limitations that can restrict the deductibility of losses from investment activities. Understanding these distinctions becomes particularly important for real estate activities and rental properties that may qualify for special tax benefits like the Section 199A deduction.

Despite these consequences, neither the tax code nor regulations define the phrase “trade or business.” One has to turn to the court cases for the definition. In Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court said that determining trade or business status requires examining all facts and circumstances in each case. Courts apply consistent standards across different code sections, including Section 162(a) for business expense deductions and Section 165(c)(1) for business loss deductions.

These court cases start with the concept of trade or busi…

These court cases start with the concept of trade or business as something that extends beyond simple profit-seeking activities. Many taxpayers engage in profit-motivated transactions that don’t rise to trade or business level.

The courts have developed a three-factor test for establi…

The courts have developed a three-factor test for establishing trade or business status. First, the taxpayer must undertake the activity with genuine profit intent rather than personal or investment motives. Second, the taxpayer must be regularly and actively engaged in the activity, demonstrating continuity and regularity rather than sporadic involvement. Third, the taxpayer’s business activities must have actually commenced, meaning the business has begun functioning as a going concern.

This third factor often proves most challenging in cases involving failed or abandoned ventures. For this factor, the courts distinguish between planning and preparation activities–which don’t constitute trade or business operations–and actual business activities that do qualify for trade or business treatment.

When Do Business Activities Actually Begin?

The leading court case for establishing when business operations commence is Richmond Television Corp. v. United States, 345 F.2d 901 (4th Cir. 1965).

In Richmond, the Fourth Circuit held that “even though a taxpayer has made a firm decision to enter into business and over a considerable period of time spent money in preparation for entering that business, he still has not ‘engaged in carrying on any trade or business’ until such time as the business has begun to function as a going concern and performed those activities for which it was organized.”

This standard requires more than research, investigation, or extensive preparation. The business must actually engage in the activities for which it was designed, even if those activities don’t immediately generate revenue or profits. A business can qualify as operational while losing money, provided it’s performing its intended functions and holding itself out to serve customers.

The distinction between pre-opening expenses and business operations becomes particularly important for hospitality ventures like hotels, restaurants, and lodges. These businesses typically require substantial investments in facilities, equipment, and infrastructure before serving their first customer.

Courts analyze whether the business has crossed the threshold from preparation into operations by examining specific operational indicators. Does the business have systems for accepting customers? Has it obtained necessary licenses and permits? Does it have employees or infrastructure capable of delivering services? Has it begun marketing to potential customers or holding itself out as available for business?

The Lodge Project Was Not a Trade or Business

In the present case, the U.S. Tax Court found that the taxpayers’ lodge venture never crossed the line from preparation into actual business operations. Despite substantial investments exceeding $5 million and genuine business intentions, the lodge failed to meet the Richmond Television standard requiring that the business “function as a going concern and perform those activities for which it was organized.”

The lodge never performed its core hospitality function of housing paying guests. The taxpayers themselves acknowledged that the lodge was never in a condition to provide lodging for paying customers. Beyond the construction defects that ultimately led to condemnation, the venture lacked basic operational infrastructure. There was no booking system for accepting reservations, no website for marketing services, no revenue processing capabilities, and no customer service procedures. The taxpayers never obtained the required innkeeper’s license or hired hospitality staff.

The court systematically rejected each of the taxpayers’ proposed business commencement dates. The 1995 land purchase couldn’t establish a hospitality business when no lodging facilities existed. Construction beginning in 2003 represented preparation rather than operations since a lodge cannot house guests while under construction. Even after construction was completed in 2006, the lodge never opened to paying customers. A single open house event in 2006 was insufficient because promotional activities don’t constitute carrying on a trade or business when the facility remains incapable of generating revenue.

The conditional use permit obtained in 2009 also failed t…

The conditional use permit obtained in 2009 also failed to demonstrate business commencement. While permits may be necessary for business operations, obtaining permits alone doesn’t prove that operations have begun. The permit contemplated additional construction that never occurred, and the existing lodge remained unsuitable for occupancy.

The court’s analysis was strengthened by comparing this c…

The court’s analysis was strengthened by comparing this case to Todd v. Commissioner, 77 T.C. 246 (1981), where a similar IRS audit revealed that abandoned real estate development plans don’t constitute trade or business activities. In Todd, a taxpayer’s “plans to enter the business of renting apartments were never realized,” making the resulting losses from abandoned plans non-deductible as business expenses. The policy underlying net operating loss provisions – allowing businesses to “set off their lean years against their lush years” – doesn’t apply when there were no operational years at all.

The taxpayers also failed the regular and active engagement test. The occasional events hosted on the property were too sporadic and disconnected from hospitality operations to establish ongoing business activity. During the construction period, the taxpayers were simultaneously operating their primary fruit processing business, and after selling that business, one spouse continued leading another company. By the time they might have focused on the lodge, construction defects had made the facility uninhabitable, shifting their attention litation and remediation rather than business development.

The Takeaway

The decision helps explain when activities become trade or business operations for tax purposes. The case shows that substantial investments, genuine business intentions, and professional development don’t create trade or business status when ventures never become operational. Construction defects, permit delays, and market conditions that prevent business opening don’t transform preparation costs into business expenses, regardless of amounts involved or underlying business legitimacy. Taxpayers contemplating similar ventures should focus on establishing operational capabilities as early as possible in development processes. While construction problems may prevent full operations, having booking systems, customer infrastructure, and revenue collection mechanisms might strengthen arguments that trade or business activity has commenced.

Watch Our Free On-Demand Webinar

In 40 minutes, we’ll teach you how to survive an IRS audit.

We’ll explain how the IRS conducts audits and how to manage and close the audit.

Source link

Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

Subscribe to Our Newsletter

Get our latest articles delivered straight to your inbox. No spam, we promise.

‘Obsession’ Rises Again in Third Weekend at Box Office, First to Do So Since ‘E.T.’ in 1982 – Just Jared – Celebrity News and Gossip

When a Spouse’s Tax Evasion Conviction Does Not Bind You – Houston Tax Attorneys

May 30, 2026

BRB Risk Jobs Board — Conflicts Counsel (Fredrikson)

May 29, 2026

Conflicts, Disclosures, Ethical Debates & Crypto Costs — Duty to Disclose in Mediation Appearance Not Mandated, Former Judicial Clerkship Not a Conflict, Alito Conflicts Allegations, Firm Settles Crypto Clash

May 28, 2026

What Makes a Tax Debt “Legally Enforceable” for Passport Certification? – Houston Tax Attorneys

When a Spouse’s Tax Evasion Conviction Does Not Bind You – Houston Tax Attorneys

May 30, 2026

BRB Risk Jobs Board — Conflicts Counsel (Fredrikson)

May 29, 2026

Conflicts, Disclosures, Ethical Debates & Crypto Costs — Duty to Disclose in Mediation Appearance Not Mandated, Former Judicial Clerkship Not a Conflict, Alito Conflicts Allegations, Firm Settles Crypto Clash

May 28, 2026

Savannah Guthrie Pleads for Nancy’s Return in Mother’s Day Post

When a Spouse’s Tax Evasion Conviction Does Not Bind You – Houston Tax Attorneys

May 30, 2026

BRB Risk Jobs Board — Conflicts Counsel (Fredrikson)

May 29, 2026

Conflicts, Disclosures, Ethical Debates & Crypto Costs — Duty to Disclose in Mediation Appearance Not Mandated, Former Judicial Clerkship Not a Conflict, Alito Conflicts Allegations, Firm Settles Crypto Clash

May 28, 2026

Recent Reviews

What Makes a Tax Debt “Legally Enforceable” for Passport Certification? – Houston Tax Attorneys

The IRS has a number of tools it can use to collect unpaid taxes. This includes liens and levies, offsetting refunds, and, since 2015, requesting that the State Department deny or revoke a taxpayer’s passport.

But what happens when a tax debt is old and seemingly beyond the collection statute of limitations? Can the IRS still certify it as “seriously delinquent” for passport purposes? What if the IRS previously obtained a default judgment against the taxpayer for tax debts for older years? Would that change the answer?

The recent Garcia v. Commissioner, 164 T.C. 8 (2025) case gets into these issues. It considers when tax debts remain “legally enforceable” for passport certification purposes, which, in turn, helps clarify how taxpayers can challenge improper certifications.

Facts & Procedural History

The taxpayer in this case accumulated over $100,000 in unpaid federal tax liabilities for the 2007 and 2010 tax periods.

As part of its IRS tax Collection efforts, the IRS filed Notices of Federal Tax Lien and sent notices of these filings to the taxpayer’s last known address. The IRS also sent Notices of Intent to Levy to the taxpayer in 2008 and in 2010.

The taxpayer requested a Collection Due Process hearing for one of the lien notices. He did not request hearings for any of the levy notices, and the time for requesting hearings on the other lien notices had expired by 2022.

In 2014, the IRS filed suit in the U.S. District Court to reduce the tax liabilities to judgment. The district court entered a default judgment against the taxpayer in late 2014. Without this judgment, the 10-year collection statute would have expired between 2017 and 2020 for most of his liabilities. The judgment probably extended the statute for another ten years.

Eight years after obtaining the judgment, in 2022, the IRS certified to the Secretary of State that the taxpayer had a “seriously delinquent tax debt” under Section 7345 of the tax code.

The taxpayer filed a petition with the U.S. Tax Court challenging the certification. He claimed that he was never served in the district court action, making the default judgment void and, since the statute had ran, his tax debt no longer legally enforceable.

What Is Section 7345 of the Tax Code?

Section 7345 was added to the tax code as part of the Fixing America’s Surface Transportation Act (“FAST Act”) in 2015. This law created a new process for the IRS to “encourage” tax compliance by limiting a delinquent taxpayer’s ability to travel internationally.

Under this section, if the IRS certifies that a taxpayer has a “seriously delinquent tax debt,” the Secretary of State may deny, revoke, or limit that taxpayer’s passport. The taxpayer can challenge this certification by filing a petition in either the Tax Court or a federal district court.

The tax court’s powers are limited in these proceedings. The tax court’s role in these cases is specifically limited to determining whether the certification was erroneous or whether the IRS has failed to reverse it when required. Thus, the court cannot address the underlying tax liability or grant any relief beyond ordering the IRS to notify the State Department that the certification was erroneous.

Readers of this site may well know that these types of compartmentalized court remedies are usually problematic, as they allow taxpayers to get one part of what they are seeking–but then deny full releif–even though all of the facts, etc. necessary for getting the full remedy are squarely before the court to get the first part of the relief.

What Qualifies as a “Seriously Delinquent Tax Debt”?

This leads to the question as to what qualifies as a “seriously delinquent tax debt.” For a tax debt to be considered “seriously delinquent” under Section 7345(b), it must meet several specific criteria.

First, it must be an “unpaid, legally enforceable Federal tax liability of an individual.” This language is important because a tax debt that is no longer legally enforceable—for example, because the collection statute of limitations has expired—cannot be certified as seriously delinquent.

Second, the debt must have been assessed by the IRS. Assessment is the formal recording of a tax liability in the IRS’s records. So basically the IRS computer has to reflect the balance as being a balance that is due.

Third, the debt must exceed a certain threshold amount, which was $50,000 when the law was enacted but is adjusted annually for inflation. In 2022, the date in this court case when the debt was certified, the threshold was $55,000.

Fourth, either (a) a notice of lien must have been filed under Section 6323 and the taxpayer’s administrative rights under Section 6320 must have been exhausted or lapsed, or (b) a levy must have been made under Section 6331.

The law also excludes certain debts from being considered “seriously delinquent,” such as those being paid in a timely manner under an installment agreement or offer in compromise, or debts for which collection is suspended due to a pending request for innocent spouse relief or a Collection Due Process hearing.

Why Is the “Legally Enforceable” Requirement So Important?

The requirement that a tax debt be “legally enforceable” to qualify as “seriously delinquent” is important. But like many important provisions in our tax laws, the term is explicitly defined in Section 7345.

At minimum, one can deduce that a tax debt is not legally enforceable if the statute of limitations for collecting it has expired. Under Section 6502(a) of the tax code, the IRS generally has 10 years from the date of assessment to collect a tax liability. This includes not only the original tax but also any interest that accrues on the unpaid liability.

In this case, most of the taxpayer’s tax liabilities were assessed between March 2007 and August 2010. Without any extension, the collection statute would have expired between March 2017 and August 2020—well before the IRS certification in October 2022.

How Do Federal Court Judgments Extend the Collection Statute?

This brings us to the extension. The 10-year collection statute can be extended in various ways, including when the United States brings an action in court to collect a tax liability and obtains a judgment. In that case, the limitations period is extended until the judgment is satisfied or becomes unenforceable after 20 more years.

When the United States obtains a judgment for unpaid taxes, the judgment creates a lien that lasts for 20 years under 28 U.S.C. §3201, and this lien may be renewed for another 20 years. This means a federal court judgment can potentially extend the IRS’s ability to collect a tax debt far beyond the original 10-year period.

In the present case, the IRS argued that the 2014 default judgment extended the collection statute until at least August 11, 2034—20 years after the judgment was entered. Ouch. If valid, this would mean that the taxpayer’s tax debt was still legally enforceable when the IRS certified it as “seriously delinquent” in October 2022. Double ouch.

Can a Taxpayer Challenge the Underlying Judgment in a Passport Case?

This gets to the default judgment part of the case. The taxpayer claimed that he was never served with the complaint in the 2014 district court action. This claim directly challenged whether the judgment extending the collection statute was valid in the first place.

Under well-established legal principles, a judgment entered without personal jurisdiction over the defendant is void. Personal jurisdiction typically requires proper service of process, which is how a court asserts its authority to adjudicate the rights of a party. This is not tax law, but rather, just the laws involved in general civil litigation.

The Supreme Court has long held that “the want of jurisdiction is a matter that may always be set up against a judgment when sought to be enforced, or where any benefit is claimed under it.” In other words, a person can challenge a judgment as void for lack of personal jurisdiction even years after it was entered if someone tries to use that judgment against them.

If the taxpayer truly was not served in the district court suit, the default judgment would be void and would not have extended the collection statute. This would mean his tax liabilities were no longer legally enforceable when the IRS certified them as “seriously delinquent” for passport purposes. That would be a great reversal of fourtune for the taxpayer.

What Is the Scope of Tax Court Review in Passport Cases?

So what did the court say and how did it get there? The first question the court had to contend with to answer this is what is the scope of the court’s review in passport certification cases? Is the court’s review limited to the administrative record that was before the IRS when it made the certification, or can the court consider new evidence presented during the tax court proceedings?

The IRS often prefers cases to be limited to the administrative record. This gives the IRS the argument that the taxpayer did not produce various items during the proceeding and, therefore, they lose their right to present anything in the court proceeding. Collection due process hearings work this way, typically.

This was important in this case because the administrative record likely contained only the default judgment and related documents. It probably didn’t include any evidence regarding whether the taxpayer was actually served in the district court action. If the tax court’s review was limited to the administrative record, it could not consider the taxpayer’s testimony about lack of service.

To answer this question, the tax court examined its jurisdictional provisions under Section 7345(e), which authorizes the court “to determine whether the certification was erroneous.” The court focused on the word “determine,” noting that in other contexts—such as deficiency redeterminations and innocent spouse relief—Congress’s use of this word signals that the court should conduct a de novo review based on a new record. This means that the court can consider more than just the administrative record.

How Did the Tax Court Rule in the Garcia Case?

Okay, so how did the court rule? The court held that a tax liability is not “legally enforceable” within the meaning of Section 7345(b) if the limitations period for collecting it has expired.

The court recognized that whether the limitations periods remained open in this case depended on whether the taxpayer was served in the district court action, which was a disputed issue of fact that could not be resolved on summary judgment.

Because the taxpayer raised a genuine issue of material fact about whether he was served in the district court action—a fact that could determine whether his tax debt was legally enforceable at the time of certification—the court denied the IRS’s motion for summary judgment.

So in short, the court didn’t really rule on the issue. Unless the case goes forward to trial and an opinion is issued, the implication of this case is that taxpayers can put on evidence to show that older taxes are time barred and therefore the IRS cannot certify the tax debt to the Secretary of State.

The Takeaway

While this case didn’t get to a final decision, the case does open the door for taxpayers to present evidence to defend against passport certifications. For those with older tax debts, this right is critical. The IRS can and does miss the statute of limitations–even in cases where it does not pursue a judgment in district court and even in cases where it does and there is no default judgment. Those with older tax debts needing to travel, should take note of the arguments made in this case as further development of the possible remedies in this area is possible and likely.