Real estate investors generally want their profits treated as capital gains instead of ordinary income. The IRS, of course, usually takes the opposite view. Few of these disputes make it to U.S. Tax Court but earlier this month, the court decided one such case. Unfortunately for real estate investors, the court sided with the IRS.
The case is important because in recent years, the court has often sided with real estate investors in deciding capital gains issues. In Cordell Pool v IRS, decided in January of 2014, the court had the opportunity to once again revisit the issue.
Section 1201(a) of the Internal Revenue Code provides for preferential treatment with respect to gain realized on the sale of a capital asset. Section 1221(a)(1) defines a capital asset as “property held by the taxpayer … but does not include… property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business”.
What does primarily mean? According to a 19966 U.S. Supreme Court decision, “primarily” for purposes of section 1221 means “of first importance” or “principally”.
Whether a taxpayer holds property primarily for sale to customers in the ordinary course of business is a factual question that must be decided on a case by case basis. The 9th Circuit Court of Appeals and Tax Court have outlined a 5 part test:
(1) the nature of the acquisition of the property;
(2) the frequency and continuity of sales over an extended time period;
(3) the nature and the extent of the taxpayer’s business,
(4) the activity of the seller about the property; and
(5) the extent and substantiality of the transactions.
Applying those tests, the court found that the taxpayer in this case acquired the property to subdivide and and sell to customers. That means profits are treated as ordinary income and not subject to the more favorable capital gains rate.
Our reading of the case is that the taxpayer might have prevailed if they were a bit more careful. While they claim the property was being held as an asset, their words and actions told a different story.
For example, the taxpayer’s IRS partnership return listed its business as “real estate development.” The term “developer” or “development” alone is enough to trigger an IRS determination that the property was primarily for sale to customers.
In another misstep, the taxpayer filed an affidavit with the county where the property was located and called itself the “developer” of a “planned unit development.”
The tax court also found that, “Frequent and substantial sales of real property more likely indicate sales in the ordinary course of business, whereas infrequent sales for significant profits are more indicative of real property held as an investment. ” Once again, here the taxpayer told the county that it had 81 sales agreements for lots.
Finally, the court found that the taxpayer built water and wastewater facilities. It found that activity was more akin to a developer than a land owner simply trying to increase the value of the property.
What is the takeaway from this decision? It is possible to get capital gains treatment for real estate. There is no bright line test that separates an investor entitled to better capital gains tax treatment from a developer. Actions speak louder than words, however.
It’s not enough to have good tax planning. The follow through is critical. Even an innocuous statement on something filed with a planning board can transform an investor into a developer.
With so many REIT funds and private placements now involved in real estate, fund promoters and hedge funds need to be careful too.
For more information, contact attorney Brian Mahany at or by telephone at (414) 704-6731 (direct). All inquiries are protected by the attorney-client privilege and kept in complete confidence. Our IRS tax lawyers handle cases anywhere in the United States.