Are proceeds from the sale of subdivided real estate capital gains or ordinary income?
Taxpayer Says: The lot sales were not part of a trade or business and are eligible for capital gains treatment.
Internal Revenue Service Says: The lot sales were made in the ordinary course of a trade or business and should be taxed at ordinary income rates.
From Internal Revenue Code Section 1221(a): A “capital asset” is broadly defined as property held by the taxpayer, whether or not connected with a trade or business, subject to a number of exceptions.
From Internal Revenue Code Section 1221(a)(1): Exceptions to Section 1221(a) include stock in trade, property of a kind that is properly included in a taxpayer’s inventory, and property held primarily for sale to customers in the ordinary course of a taxpayer’s trade or business.
From Raymond v. Commissioner, T.C. Memo. 2001-96 (citing Cottle v. Commissioner, 89 T.C. 467, 487 (1987)): The question of whether property is held primarily for sale to customers in the ordinary course of a taxpayer’s business is “purely factual,” and to answer it, we look to the taxpayer’s intent at the time of the property’s disposition.
THE CAUSE OF THE DISPUTE
The determination of whether you’re a real estate investor or dealer depends on the primary reason you buy, hold and sell property.
In general, you’re considered a real estate dealer if you make a regular habit of selling property in order to derive gains and profits. The real estate is either ‘held primarily for sale’ or is inventory and your profit is taxed at ordinary income rates.
On the other hand, you’re not typically considered a dealer if you merely hold real estate for investment or speculation. In that situation, the property is a capital asset, and your gains are taxed at capital gains rates.
Disputes arise because your “primary purpose for holding property” is based on a number of factors, no one of which is individually determinative. Factors include:
- why you bought the property and how long you own it
- your everyday business and the relationship of realty income to your total income
- how often you sell property
- how much work you put into developing and improving the property in order to sell it
- how many sales you make
- whether you use a business office to make sales
- the level of control you have over any representative who is selling the property for you
- how much advertising you do to sell the property
- how much time you spend trying to sell the property
In this case, the taxpayer, a self-employed manager of 401(k) plans, purchased acreage with the intention of building a home. He improved the property and subdivided it into ten lots. He built his home on one lot and sold seven others over the course of eight years. The sales were his only real estate activities during that time, and he purchased no additional property to replace the lots sold.
The taxpayer says the lots were capital assets, the sales did not rise to the level of a business, and the profits qualify for capital gains treatment.
The IRS says the sales were made primarily in the course of the taxpayer’s business and are subject to ordinary income tax rates.
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.