Schwarz v. Commissioner (Supplemental Opinion)

Loper Bright Fails to Save Hobby Loss Case

Having previously lost a hobby loss case before the Tax Court, Schwarz v. Commissioner (Schwarz I), husband and wife taxpayers sought to revive their disallowed deductions by arguing that recent Supreme Court precedent had invalidated the Treasury Regulations under Section 183. Section 183, often called the "hobby loss rule," prevents taxpayers from deducting losses from activities "not engaged in for profit," effectively preventing hobbies from being used to generate tax losses. In a strategic move seemingly aimed at insulating its decision from administrative law challenges, the Tax Court declined to rule on the regulations' validity. Instead, the court held that, regardless of whether the regulations are valid, the taxpayers failed to prove a profit motive under existing caselaw and the raw numbers.

The Procedural Pivot: From Schwarz I to Reconsideration

The Tax Court's initial ruling, Schwarz I, filed on May 13, 2024, denied the partnership's deductions, citing Treasury Regulations §§ 1.183-1(d)(1) and 1.183-2(b) extensively, without addressing their validity. These regulations elaborate on Section 183, which, through the "hobby loss rule," prevents taxpayers from deducting losses from activities "not engaged in for profit," effectively preventing hobbies from being used to generate tax losses. In a strategic move seemingly aimed at insulating its decision from administrative law challenges, the Tax Court declined to rule on the regulations' validity. Instead, the court held that, regardless of whether the regulations are valid, the taxpayers failed to prove a profit motive under existing caselaw and the raw numbers.

However, the legal landscape shifted dramatically on June 28, 2024, when the Supreme Court issued Loper Bright Enterprises v. Raimondo. This landmark decision overruled Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., a case that had previously dictated the standard of review courts were to employ when evaluating an agency's interpretation of a statute. Loper Bright established that if an agency's interpretation "is not the best, it is not permissible."

In response, on September 16, 2024, the Petitioners filed a Motion for Reconsideration, directly attacking the validity of Treasury Regulations §§ 1.183-1(d)(1) and 1.183-2(b) in light of Loper Bright. They argued that the Tax Court should "reconsider [its] holding" and interpret Section 183 independently, rather than deferring to the potentially invalid regulations. The IRS objected to the motion on November 1, 2024. Nevertheless, on November 5, 2024, the Tax Court granted the Motion for Reconsideration "insomuch that the Court will reconsider" Schwarz I. The court then ordered both parties to file briefs addressing relevant caselaw, the Treasury Secretary's authority to issue regulations regarding Section 183, the history of the regulations, and, crucially, "if any portion of the regulations is found to be invalid, how the Court should evaluate the facts of this case and whether there would be any effect on the outcome." This procedural pivot set the stage for a re-evaluation of the facts, potentially free from the constraints of regulations deemed invalid under Loper Bright.

Dismantling the Expert: Muddy Lakes and Math Errors

Following the request to address relevant caselaw and the validity of Treasury regulations regarding Section 183, which governs the deductibility of expenses for activities not engaged in for profit, the court turned to the factual underpinnings of the taxpayer's case. The taxpayer, in an effort to demonstrate a profit motive, argued that the appreciation of the land, specifically due to "major water features" like lakes, should offset farming losses. This argument hinged on the testimony of their expert witness, Mr. Swanson, whose valuations came under intense scrutiny.

Judge Goeke first took aim at Swanson's valuation of the "major water features." Swanson asserted that the presence of lakes on the La Perla HQ Tract and Jalisco Ranch doubled the value of the underlying land. To support this claim, he presented nine "case studies" comparing properties with and without significant water features, all located hundreds of miles from the ranches in question. The court found these comparables questionable, particularly given the differing weather and precipitation patterns across Texas.

More critically, Judge Goeke highlighted the existence of a closer, more relevant comparable: Twin Lakes South, a property contiguous to the La Perla HQ Tract. Swanson himself had used the sale of Twin Lakes South (which had a "±30 surface acre lake") as a comparable for valuing the underlying land but failed to include it in his water feature analysis. Despite acknowledging the lake on Twin Lakes South, Swanson dismissed its significance, claiming it was "muddy" and therefore less valuable than the clearer lakes on La Perla. The court found this explanation unpersuasive, noting that the fisheries expert advising the taxpayer had documented water clarity issues at La Perla and Jalisco Lakes as well and testified that the lakes could be cleared quickly with gypsum.

The court then observed that Twin Lakes South sold for only marginally more per acre than Twin Lakes North (which had only a 3-acre stock tank), despite being smaller and having superior water rights. This suggested that the market placed a relatively low value on the 30-acre lake on Twin Lakes South. Ultimately, the court concluded that the lake on Twin Lakes South added only 5-20% to the land value, not the nearly 100% premium Swanson claimed for the La Perla and Jalisco lakes.

Beyond the water feature valuations, Judge Goeke identified a critical mathematical error in Swanson's valuation of the underlying land. In determining the "adjusted price/acre" for comparable properties, Swanson added dollar-per-acre adjustments for water rights, irrigation systems, and improvements. He then multiplied this subtotal by percentage adjustments for factors like location and land features. Finally, he subtracted the original dollar-per-acre values for water rights, irrigation, and improvements. The court explained that Swanson's method improperly added the value adjustments, allowed them to be multiplied by mostly positive percentages, and then subtracted out the original values. This inflated the value assigned to the underlying land. As an example, the court noted that the Bell Ranch sale would have been only $1,975 per acre, had he not incorrectly added the values to begin with.

Correcting this error resulted in an average price per acre reduction of $296 for the La Perla HQ Tract (about $363,000 total) and $62 for Jalisco Ranch (about $50,000 total). As a result of these findings, the court significantly slashed Swanson's valuations of La Perla HQ and Jalisco Ranch.

The Legal Argument: Caselaw vs. Regulations

The Petitioners launched a multi-pronged attack against the IRS's reliance on Treasury Regulations in determining profit motive. Central to their argument was the Supreme Court's decision in Loper Bright Enterprises v. Raimondo, 603 U.S. 369 (2024), which overruled the Chevron doctrine. Under Chevron, courts were required to defer to an agency’s reasonable interpretation of an ambiguous statute. The Petitioners argued that Loper Bright invalidated Treasury Regulations § 1.183-2(b)(1)-(9), which lists nine factors used to assess profit motive. They proposed an alternative test for determining whether an activity is engaged in for profit, one that purportedly excluded subjective intent.

The Tax Court, however, sidestepped the Loper Bright argument by tracing the origins of Section 183, which addresses activities not engaged in for profit, back to pre-1969 caselaw. The court cited cases interpreting Sections 162 and 212 of the Code, which allow deductions for ordinary and necessary business expenses and expenses for the production of income, respectively, noting that these sections have long required a profit motive for expenses to be deductible. The Judge reasoned that the nine factors outlined in the Treasury Regulations were merely a distillation and summary of principles established in this older body of common law. Therefore, the court concluded, even if the regulations were invalid under Loper Bright, the underlying factors used to determine profit motive survived as common law principles.

The court acknowledged a tension in precedent, noting the Seventh Circuit's description of a similar regulation as "goofy" versus the Fifth Circuit's approach. However, it did not explicitly weigh in on this circuit split, finding that the factors themselves remained relevant regardless.

Grouping Activities Without the Regulations

The court acknowledged a tension in precedent, noting the Seventh Circuit's description of a similar regulation as "goofy" versus the Fifth Circuit's approach. However, it did not explicitly weigh in on this circuit split, finding that the factors themselves remained relevant regardless.

The taxpayers argued that, even if Treasury Regulation § 1.183-1(d)(1) was invalid, their farming and real estate activities should be considered a single undertaking. Treasury Regulation § 1.183-1(d)(1) addresses the scenario "[w]here land is purchased or held primarily with the intent to profit from increase in its value, and the taxpayer also engages in farming on such land." In that circumstance, the regulation states that "the farming and the holding of the land will ordinarily be considered a single activity only if the farming activity reduces the net cost of carrying the land for its appreciation in value."

The taxpayers contended that Congress intended farming and landholding to be presumed a single activity unless proven otherwise. They pointed to legislative history from Section 183, which disallows deductions for activities not engaged in for profit, arguing that Congress expected activities to be defined "[a]s under present law." They further claimed that pre-Section 183 precedent established that farming and holding farmland were almost always sufficiently interrelated to constitute one business unit.

The court rejected this argument. It noted that Section 183 itself provides no definition for "separate activity." The court also gave little weight to Treasury Regulation § 1.270-1(a)(4), which the taxpayers cited to support their argument. Section 270 was enacted in 1954 and disallowed certain deductions for trades or businesses which lost over $50,000 for each of five consecutive years. Treasury Regulation § 1.270-1(a)(4) states that, where several business activities emanate from a single commodity, such as oil or gas or a tract of land, it does not necessarily follow that such activities are one business for the purposes of section 270. But the court noted that Section 270 had not applied since 1969.

Absent specific statutory guidance, the court turned to relevant caselaw. While the taxpayers cited several Tax Court opinions treating farming and landholding as one activity, the court found that none of those cases substantively considered whether the farming activities were separate from the landholding. The court emphasized that whether undertakings constitute one or more activities is a question of fact.

Referencing cases like Collins v. Commissioner, 34 T.C. 592 (1960), and Davis v. Commissioner, 65 T.C. 1014 (1976), the court applied general caselaw factors for determining whether undertakings constitute one or more activities. These factors included the location of the activities, whether they shared management, and whether they maintained separate books and records. Applying these "commonsense" factors, the court concluded that the taxpayers' farming activity and real estate activities remained separate, even without relying on the specific "farming and land test" outlined in the potentially invalid regulation.

Conclusion: Losses Outweigh Appreciation

Even if the court accepted the taxpayer's argument to treat the farming and real estate activities as a single undertaking, the court found that the outcome of the case would not change. The Tax Court reiterated its prior conclusion that the taxpayer's farming losses were so substantial that they dwarfed any potential appreciation in the real estate holdings. The court noted that Treasury Regulation Section 1.183-2(b) provides a list of nine factors for determining whether an activity is engaged in for profit. However, even without relying on those factors, the court found that the farming activity generated over $12 million in losses, which far outweighed the unrealized gains from the land, especially after the court reduced the valuations of the La Perla HQ Tract and Jalisco Ranch in the previous section. Therefore, the court again held that the taxpayer's farming activity was not engaged in for profit during the years at issue.

Impact: Loper Bright challenges may open the door to reconsideration of regulations, but they do not cure underlying bad facts or unfavorable statutory history. Even a successful challenge to a specific regulation will not change the outcome if the court can reach the same conclusion based on other regulations, caselaw, and the specific facts presented. Taxpayers must still demonstrate a genuine profit motive, and a history of significant losses will always be a major obstacle.