Is a loss on the abandonment of an option to purchase real property a capital or ordinary loss?
Taxpayer Says: The property underlying the asset was purchased in the ordinary course of business, and the loss should be an ordinary loss.
Internal Revenue Service Says: The property was a capital asset, and the loss is a capital loss.
From Internal Revenue Code Section 1221: Defines a capital asset as any property held by the taxpayer, whether or not connected with his or her trade or business.
From Internal Revenue Code Section 1221(a)(1): Creates an exception to the definition of a capital asset for “stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”
From Internal Revenue Code Section 1234(a)(1): Provides as a general rule: Gain or loss attributable to the sale or exchange of, or loss attributable to failure to exercise, an option to buy or sell property shall be considered gain or loss from the sale or exchange of property which has the same character as the property to which the option relates has in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him).
THE CAUSE OF THE DISPUTE
When you buy a real estate option, you are buying the right to purchase a property at a certain price in a certain time period. If you fail to exercise the option, for tax purposes you sold an asset, and you may be able to claim a loss.
If the property you were seeking to buy would have been a capital asset—that is, it would have been investment property—the loss is a capital loss, and subject to capital loss rules, which restrict deductibility.
If the property would have been an ordinary asset, such as something you would have held primarily for sale to customers in the ordinary course of your trade or business, you have an ordinary loss, which may be more advantageous from a tax perspective.
Factors considered in determining whether the property would have been a capital asset or an ordinary asset include:
(1) your purpose in acquiring the property and the duration of your ownership,
(2) the purpose for which the property was subsequently held;
(3) your everyday business and the relationship of realty income to total income,
(4) the frequency, continuity, and substantiality of sales of property,
(5) the extent of developing and improving the property to increase sales,
(6) the extent to which you used advertising, promotion, or other activities to increase sales,
(7) the use of a business office for the sale of property,
(8) the character and degree of supervision or control you exercised over any representative selling the property, and
(9) the time and effort you habitually devoted to the sales.
In this case, the taxpayer worked as a general manager for a real estate developer and also operated a side business purchasing, improving and re-selling run-down properties. In 2005 and 2006, he purchased six properties, three of which he improved and unsuccessfully attempted to sell, and three as rental investments.
In 2007, the taxpayer received a real estate license, and entered into an option to buy another property. The option contract provided that he would be allowed the period between May 2007 and the close of escrow “to develop the property for its highest and best use” and that the sellers of the property would “cooperate in any and all ways necessary and in a timely way to develop the property accordingly.”
The taxpayer put down $30,000 and agreed to pay $3,000 per month until closing. He spent approximately 20 hours per week searching for partners and investors and vetting, investigating, and developing the property before abandoning the option in March 2008. Upon abandonment, he forfeited $48,000 of deposits made, and took an ordinary deduction for the loss.
He argues he did not purchase the property with the hope that it would appreciate over time like an investment. Instead, he purchased the property with the intent “to create value by actively improving it and selling to multiple buyers/builders for profit and income.” He further contends that during the year in issue (2008) he was in the trade or business of, among other things, improving dilapidated properties for sale and profit (flipping)” and “developing raw land with the intent to actively work to improve value and sell at a profit.”
While not disputing that the taxpayer was in a trade or business, the IRS says the loss was a capital loss. The argument: The taxpayer purchased the option as an investment, and the property would have been a capital asset in his hands had he exercised the option. In addition, the taxpayer never held real property for sale to customers in the ordinary course of his trade or business. Instead, he was only in the trade or business of locating, developing, and selling real property for third parties.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.