When Can I Deduct an Expense?

When you deduct an expense depends on your accounting method. An accounting method is a set of rules used to determine when and how income and expenses are reported. The two basic methods are the cash method and an accrual method.

For more information on accounting methods, see Publication 538.

Cash method.   Under the cash method of accounting, you generally deduct business expenses in the tax year you actually paid them, even if you incurred them in an earlier year.

Accrual method.   Under an accrual method of accounting, you generally deduct business expenses when both of the following apply.

1. The all-events test has been met. The test is met when:
   1. All events have occurred that fix the fact of liability, and
   2. The liability can be determined with reasonable accuracy.
2. Economic performance has occurred.

Economic performance.   You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided, or the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.

Example.   Your tax year is the calendar year. In December 2002, the Field Plumbing Company did some repair work at your place of business and sent you a bill for $150. You paid it by check in January 2003. If you use an accrual method of accounting, deduct the $150 on your tax return for 2002 because all events occurred to fix the fact of liability, the liability can be determined, and economic performance occurred in that year. If you use the cash method of accounting, you can deduct the expense on your 2003 return.

Prepayment.   You generally cannot deduct expenses in advance, even if you pay them in advance. This rule applies to both the cash and accrual methods. It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.

Example.   In 2002, you sign a 10-year lease and immediately pay your rent for the first 3 years. Even though you paid the rent for 2002, 2003, and 2004, you can deduct only the rent for 2002 on your current tax return. You can deduct on your 2003 and 2004 tax returns the rent for those years.

Contested liability.   Under the cash method, you can deduct a contested liability only in the year you pay the liability. Under an accrual method, you can deduct contested liabilities, such as taxes (except foreign or U.S. possession income, war profits, and excess profits taxes), 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 certain conditions. See Contested Liability in Publication 538 for more information.

Related person.   Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not paid them. However, if you and the person you owe are related and the person uses the cash method of accounting, you must pay the expense before you can deduct it. The deduction by an accrual method payer is allowed when the corresponding amount is includible in income by the related cash method payee. See Related Persons in Publication 538.

Not-for-Profit Activities

If you do not carry on your business or investment activity to make a profit, there is a limit on the deductions you can take. You cannot use a loss from the activity to offset other income. Activities you do as a hobby, or mainly for sport or recreation, come under this limit. So does an investment activity intended only to produce tax losses for the investors.

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, all the facts are taken into account. No one factor alone is decisive. Among the factors to consider are whether:

1. You carry on the activity in a businesslike manner,
2. The time and effort you put into the activity indicate you intend to make it profitable,
3. You depend on income from the activity for your livelihood,
4. Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
5. You change your methods of operation in an attempt to improve profitability,
6. You, or your advisors, have the knowledge needed to carry on the activity as a successful business,
7. You were successful in making a profit in similar activities in the past,
8. The activity makes a profit in some years, and how much profit it makes, and
9. You can expect to make a future profit from the appreciation of the assets used in the activity.

Presumption of profit.   An activity is presumed 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 produced 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 is more than the deductions for it.

If a taxpayer dies before the end of the 5-year (or 7-year) period, the 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, 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 in every case, unless the IRS shows it is not valid.

Using the presumption later.   If you are starting an activity and do not have 3 (or 2) years showing a profit, you may want to elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test.

You can choose 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 choice 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 3 (or 2) out of the first 5 (or 7) years you carry on the activity. If you show 3 (or 2) years of profit at the end of this period, your deductions 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 in the 5-year (or 7-year) period with a loss.

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 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 return for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow deductions attributable to the activity.

Limit on Deductions and Losses

If your activity is not carried on for profit, take deductions only in the following order, only to the extent stated in the three categories, and, if you are an individual, only if you itemize them on Schedule A (Form 1040).

Category 1.   Deductions you can take for personal as well as for business activities are allowed in full. For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. Deduct them on the appropriate lines of Schedule A (Form 1040). You can deduct a casualty loss on property you own for personal use only to the extent it is more than $100 and all these losses are more than 10% of your adjusted gross income. See Publication 547 for more information on casualty losses. For the limits that apply to mortgage interest, see Publication 936.

Category 2.   Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than the deductions you take (or could take) under the first category. Most business deductions, such as those for advertising, insurance premiums, interest, utilities, wages, etc., belong in this category.

Category 3.   Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity is more than deductions you take (or could take) under the first two categories. The deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. Where more than one asset is involved, divide depreciation and these other deductions proportionally among those assets.

Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A (Form 1040). They are subject to the 2%-of-adjusted-gross-income limit. See Publication 529 for information on this limit.

Example.   Ida is engaged in a not-for-profit activity. The income and expenses of the activity are as follows.

Gross income		$3,200
Minus expenses:
Real estate taxes	$700
Home mortgage interest	900
Insurance	400
Utilities	700
Maintenance	200
Depreciation on an automobile	600
Depreciation on a machine	200	3,700
Loss		$ 500

Ida must limit her deductions to $3,200, the gross income she earned from the activity. The limit is reached in category (3), as follows.

Limit on deduction		$3,200
Category 1: Taxes and interest	$1,600
Category 2: Insurance, utilities, and maintenance	1,300	2,900
Available for Category 3		$ 300

The $300 for depreciation is divided between the automobile and machine as follows.

$600 / $800	x	$300	=	$225	depreciation for the automobile
$200 / $800	x	$300	=	$75	depreciation for the machine

The basis of each asset is reduced accordingly.

The $1,600 for category (1) is deductible in full on the appropriate lines for taxes and interest on Schedule A (Form 1040). Ida deducts the remaining $1,600 (the total of categories (2) and (3)) as other miscellaneous deductions on Schedule A (Form 1040) subject to the 2%-of-adjusted-gross-income limit.

Partnerships and S corporations.   If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. They are reflected in the individual shareholder's or partner's distributive shares.

More than one activity.   If you have several undertakings, each may be a separate activity or several undertakings may be one activity. The following are the most significant facts and circumstances in making this determination.

• The degree of organizational and economic interrelationship of various undertakings.
• The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a business or investment setting.
• The similarity of various undertakings.

The IRS will generally accept your characterization of several undertakings as one activity, or more than one activity, if supported by facts and circumstances.

If you are carrying on two or more different activities, keep the deductions and income from each one separate. Figure separately whether each is a not-for-profit activity. Then figure the limit on deductions and losses separately for each activity that is not for profit.

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