Small Business Taxes & ManagementTM--Copyright 2009-2011, A/N Group, Inc.
If you invest in stocks, determining whether a sale generates a long-term capital gain or ordinary income is usually easy. Hold the shares for more than one year and the gain is long term and taxed at favorable rates. However, if you're investing in real estate, things can get much trickier. If you regularly deal in real estate, such as a developer or a real estate agent, you've got to be particularly alert. But even sales by a casual investor can be challenged by the IRS.
Regardless of the holding period, not all property qualifies for capital asset treatment. Generally, nonbusiness property including your residence, auto, stamp collection, etc. is a capital asset and if sold at a profit, qualify for capital gain treatment. (But you can't take a capital loss unless the property was held for investment.) Depreciable business assets and land used in a business are not capital assets, but, under another Code Section (1231) they can get special treatment.
Property held for sale in the ordinary course of business (inventory property) is never a capital asset. This is where real estate developers and agents, other dealers in property (such as art or antique dealers) and, occasionally investors, get into trouble. Sometimes it's clear that the property is inventory. For example, a real estate developer who purchases 100 acres of land and promptly subdivides and begins advertising and selling either bare land or lots with houses constructed. But other times it's not so obvious. That can be the case where a developer or real estate professional owns a number of rental properties and sells one or more. Were the properties held for investment or as inventory for sale? If held for investment the property could be a capital asset. Another example is an art dealer who has held a painting for a number of years in his private home, never offering it for sale.
The outcome turns on whether the property was held primarily for sale. In Malat v. Riddell the United States Supreme Court defined "primarily" to mean "principally" or "of first importance." Some of the tests that have been applied to determine whether the property is held for investment or primarily for sale include:
Real Property Subdivided for Sale
Section 1237 provides a special rule for determining whether a taxpayer holds real property primarily for sale to customers in the ordinary course of his business under Sec. 1221(1). This rule permits taxpayers qualifying under it to sell real estate from a single tract held for investment without the gain being treated as ordinary income merely as a result of subdividing the tract or of active efforts to sell it. The rule is not applicable to dealers in real estate or C corporations. In addition, if there is other substantial evidence to show that the taxpayer held real property for sale to customers in the ordinary course of business, activities in connection with the subdivision and sale of the property will be taken into account.
Three conditions must be met:
If more than 5 lots or parcels contained in the same tract of real property are sold or exchanged, gain from any sale or exchange (which occurs in or after the taxable year in which the sixth lot or parcel is sold) of any lot or parcel which meets the requirements above will be treated as capital gain except that up to 5 percent of the selling price will be considered ordinary income.
As always, the rules can be more complex. Some improvements are allowed, although, depending on the nature, a 10-year holding period may be required to still come under this Code Section. While this provision won't prove a panacea for all taxpayers attempting to subdivide real property, remaining within its guidelines could be helpful for many property owners.
Taxpayer Wins Subdivision Issue
Most IRS denials of capital gain treatment for taxpayers subdividing real estate involve real estate agents, dealers, developers, etc. who own property that they are developing and clearly hold for sale to customers and property that they claim is held for investment or rental properties. In a recent case (Bruce A. Rice et ux.; T.C. Memo. 2009-142) the taxpayers bought a 14 acre parcel of undeveloped property in a desirable location on which to build their dream home. While the property was much larger than desired, it was cheaper per acre than other properties they had looked at. The property could only be purchased as a single unit. The taxpayers initially wanted to keep the entire property, but the wife changed her mind, fearing it would be too isolated. That led to the decision to subdivide.
The taxpayers had never engaged in the sale of real estate other than sales of their own personal residences before they purchased this property, nor have they engaged in it since. They first identified the portion of the property they wanted for their lot. This lot was the largest and was in a desirable place on the property. They had to hire consultants for zoning, access, water and wastewater service, construction, and environmental issues. After they decided to subdivide the property, they hired a consultant to provide a subdivision layout. They applied for and received a zoning change to subdivide and develop the property. The taxpayers divided the property into ten smaller lots, reserving eight lots for homes and two lots for environmental purposes.
The taxpayers did not want just any neighbors. They wanted neighbors with money. They registered the subdivision for a homeowner's association and executed a declaration of covenants, conditions and restrictions, which applied to all the lots in the subdivision (other than Lots 9 and 10 that fell outside the subdivision). They took two years to construct their dream home. The taxpayers devoted a significant amount of their spare time to building their home, and their home was the focus of their attention.
The Court looked at the factors cited above. The record showed that they sold the excess lots to dispose of unwanted property, not that they purchased the property primarily for sale to customers in the ordinary course of business. The taxpayer looked at other properties, but the one they purchased was in the school district where they wanted to live, provided them with enough space to build their dream home, and was much cheaper than the other properties they considered purchasing. They did not have the option to buy a smaller portion of the property.
The number of lots the taxpayers sold in total was small. The Court of Appeals for the Fifth Circuit has held that substantiality and frequency of sales is among the most important factors. The taxpayers did not sell an average of a lot a year. Among the eight lots suitable for construction, they sold one lot in 2000, three lots in 2004, one lot in 2005, one lot in 2007, and one lot in 2008, and they are holding one in reserve for their daughter. These sales are few and infrequent in comparison to the sales in the cases the IRS cited.
The taxpayers made significant improvements to develop and sell the excess lots (generally, a negative). The Court noted, however, that many of those improvements would have been necessary even had they not subdivided the property. Building their own residence on the property required significant expenditures for improvements. Solicitation and advertising efforts and brokerage activities are also significant factors in analyzing whether property sales are eligible for capital gains or ordinary treatment. The taxpayers devoted very little time to the sale of the excess lots. The lots were sold primarily to friends, friends of friends, and relatives. Other than posting a sign outside the subdivision, petitioners did not advertise or promote the sale of lots. The taxpayers' solicitation and advertising efforts are more characteristic of those of investors than of dealers.
Finally, the taxpayers had full-time jobs and devoted little time to the sale of the excess lots. Lot sales accounted for a small percentage of their income each year, and they retained the proceeds rather than buying additional inventory. The taxpayers were not real estate developers, had never developed land before, and have never developed land since. The Court concluded that they purchased the property as an investment and not as property held for customers in the ordinary course of business.
The interesting issue here is not that the taxpayers won, but that the IRS challenged them at all. It would have appeared that there was little support for the claim that the taxpayers were in the business of selling real estate. But it shows that many taxpayers could be at risk. Knowing that in advance you can minimize your risk by setting a fact pattern early on that would indicate you're not in the business of selling real property. For example, keep improvements to a minimum, avoid advertising the property (use word of mouth as much as possible), keep the number of sales per year to a minimum, etc. While not advertising may limit sales potential, you may be able to overcome that by pricing the land under the market. A price somewhat below will make the property more attractive. While you may get less, the gain you retain is likely to be higher if you're only paying tax at long-term capital gains rate on the gain. Get good advice and work through the numbers.
Another Taxpayer Has Ordinary Income
In another case Wendell V. Garrison et ux. (T.C. Memo. 2010-261) the taxpayers' situation was different. They sold at least 15 properties over 3 years, and most of the sales occurred within 4 months after they purchased the property. The husband was a mortgage banker during the years at issue, but the income from the sales of property was much more than that from his job. In fact, the real estate sales constituted the taxpayers primary source of income. The Court noted the factors listed above plus two more: the taxpayer's everyday business and the relationship of the income from the property to the total income, and the use of a business office for the sale of property (not a factor here).
The Court noted the frequency, continuity and substantiality of the taxpayers' sales as well as the rapid sale of acquired properties and found the sales gave rise to ordinary income, not long-term capital gains. The Court also found the taxpayers were engaged in the trade or business of purchasing and selling real property and their net earnings were subject to the self-employment tax.
Copyright 2009-2011 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 10/06/11