Is the sale of real property acquired by tax deeds capital gain or ordinary income?
Taxpayer Says: Sales of real properties were not frequent in comparison to the number of certificates of purchase of tax lien acquired during the years at issue. The sales should be treated as capital gain.
Internal Revenue Service Says: The sales of real properties were frequent and regular for each year without any trend to holding the properties as investments. The sales are ordinary business income.
From Internal Revenue Code Section 1221: Provides that a capital asset is “property held by the taxpayer (whether or not connected with his trade or business).”
From Internal Revenue Code Section 1221(a)(1)-(8): Congress has provided in section 1221 eight specific types of property excepted from the definition of a capital asset. One of these exceptions provides that the term “capital asset” does not include “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” See sec. 1221(a)(1).
From Malat v. Riddell, 383 U.S. 569, 572 (1966): The term “primarily” for purposes of section 1221 means “of first importance” or “principally.” Congress intended that capital asset treatment be an exception to the normal requirements of the Code and that the profits generated by everyday business operations be ordinary income. “The purpose of * * * [section 1221] is to differentiate between the ‘profits and losses arising from the everyday operation of a business’ on the one hand * * * and * * * ‘the realization of appreciation in value accrued over a substantial period of time’ on the other.”
From Sovereign v. Commissioner, 281 F.2d at 833: Courts consider numerous factors when deciding the taxpayer’s primary purpose for holding property. The factors include: (1) the frequency and regularity of sales of real properties; (2) the substantiality of the sales and the relative amounts of income taxpayers derived from their regular business and the sales of real properties; (3) the length of time the taxpayers held the real properties; (4) the nature and extent of the taxpayers’ business and the relationship of the real properties to that business; (5) the purpose for which the taxpayers acquired and held the real properties before sale; (6) the extent of the taxpayers’ efforts to sell the property by advertising or otherwise; and (7) any improvements the taxpayers made to the real properties.
From Phelan v. Commissioner, T.C. Memo. 2004-206: As a general matter, frequent, regular, and substantial sales of real property are indicative of sales being made in the ordinary course of a trade or business, whereas infrequent sales of these properties are more indicative of real property held for investment purposes.
THE CAUSE OF THE DISPUTE
Under current tax law, when you sell a capital asset and have a taxable gain, you benefit from tax rates that are lower than those levied on ordinary income. That’s also true of passthrough entities such as “S” corporations and partnerships, because the income retains its character when passed through to the shareholder or partner and is taxed at their rates. (Note there are no special capital gain tax rates for “C” corporations.)
However, capital assets are defined in the code by what they are not—for example, property you hold out for sale in the ordinary course of your business is not capital in nature. Generally, to determine the purpose for which property is primarily held, the tax court will look to your purpose at the time the property was sold. The court can consider events that occurred before the sale and will apply several factors when deciding your primary purpose for holding property. (See “The Law” section above for a list of the factors.)
In this case, the question involves whether sales of real properties acquired by tax liens were sales of capital assets or sales made in the ordinary course of business.
The taxpayer, three related limited liability companies that were treated as partnerships, participated in Illinois real estate tax lien auctions during 2007 and 2008. The taxpayer bid on and acquired certificates of purchase of tax lien at public auctions.
In Illinois, when a property owner fails to pay real estate tax, the county tax collector applies for a circuit court judgment to sell a lien on the property in the amount of the unpaid taxes and the costs of the sale. Investors bid on the liens (the property itself is not sold in the auction). If the property owner does not pay the back taxes plus the fees and interest on the lien after a certain time period, the tax lien investor can acquire a tax deed and sell the property. Tax lien investors make money on the interest when the lien is paid off, or from the sale of the property if the lien is not satisfied.
As a purchaser of tax liens, the taxpayer’s income came from sales of real estate acquired via the lien process as well as the interest income on the liens (called penalty percentage rates). The taxpayer reported the interest as ordinary income and the real estate sales as capital gains, either long-term or short-term depending on the holding period.
During 2007, the taxpayer sold 103 properties, typically within a year of acquisition, and reported capital gains of $2,427,237 and a business loss of $1,337,042. During 2008, the taxpayer sold 156 properties and reported capital gains of $1,340,378 and a business loss of $161,401. At the end of the 2007 and 2008 tax years the taxpayer carried on its balance sheets approximately 6,500 certificates of purchase of tax lien.
The IRS says the taxpayer is not entitled to capital gains treatment for the sales of real properties. Instead, the IRS says the sales of real properties were frequent and regular for each year without any trend to holding the properties as investments. Because the taxpayer held the real estate properties it acquired by tax deeds primarily for sale to customers in the ordinary course of its trade or business, the proceeds from sales of these real properties should be classified as ordinary income.
The taxpayer disagrees. It contends that income from the sales should be treated as gains from capital assets. It says the sales of real properties were not frequent in comparison to the number of certificates of purchase of tax lien acquired during the years at issue. Instead of real estate sales, the taxpayer’s business was based on profiting on the spread between the interest rates charged against the lines of credit used to purchase tax liens and the penalty rates received if and when the certificates of purchase of tax lien were redeemed.
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We give little weight to the fact that the taxpayer acquired more certificates of purchase of tax lien than tax deeds. In sum, the sales of real properties were frequent and regular during the years at issue. The taxpayer’s own accounting records, as well as the testimony presented at trial, showed that the taxpayer desired to dispose of the real properties quickly and frequently and with the intent to make a profit and was successful [in doing so]. In fact most of the properties sold by quitclaim deed during the years at issue were sold within one year of acquisition.
The record also shows that the sales of real properties were substantial during the years at issue, especially when viewed with respect to the total amounts of income earned in those years.
The nature of the trade or business, the relationship of the sales of real property to the trade or business, and the sales of real estate properties being in furtherance of the trade or business also weigh against the taxpayer.
Although the taxpayer contends the primary business purpose in acquiring the certificates of purchase of tax lien was to make a profit on the penalty rates and not to acquire real estate properties, the record shows that the sales of these real properties were an integral components in the trade or business, permitting a profit from both the acquisition of the certificates of purchase of tax lien and the sales of properties if those certificates were not redeemed.
In light of the foregoing, we conclude that the real properties acquired from certificates of purchase of tax lien and converted into tax deeds are properties held primarily for sale to customers in the ordinary course of the trade or business.
Editorial note: The taxpayer was also required to use accrual accounting and was unable to report the property sales under the installment method.