Case — Property Sale – Personal, Capital or Ordinary?

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TL Case Summ

THE QUESTION

Is a loss on the sale of a house and land a nondeductible personal loss, an ordinary business loss, or an investment capital loss?

THE DISPUTE

Taxpayer Says: The property was purchased in the course of business, and the loss is ordinary, and can be deducted in the year of sale and be carried forward to future years.

Internal Revenue Service Says: The loss is personal and nondeductible because the taxpayer intended to live in the residence. Alternatively, the property was purchased as an investment and the loss is a capital loss.

THE LAW

From Internal Revenue Code Section 1221: Defines all property held by a taxpayer as a “capital asset” and then explicitly excludes eight categories of property. Sec. 1221(a) provides in pertinent part as follows: SEC. 1221. CAPITAL ASSET DEFINED. (a) In General.–For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include– (1) 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 Finnegan v. Commissioner, T.C. Memo. 1997-486: “[A] taxpayer engaged in a single venture can be found to be in a trade or business in ‘situations where, at the time the property was acquired by the taxpayer, he intended promptly to resell the property and the objective facts show that he proceeded to attempt to implement that intent’. Morley v. Commissioner, supra at 1211.”

THE CAUSE OF THE DISPUTE

When you sell property at a loss, the amount you can deduct on your tax return depends on the type of asset you sell. For instance, when you have a loss on your home, the loss is nondeductible because your home is a personal asset.

Disputes between taxpayers and the Internal Revenue Service arise over the classification of losses because some losses provide a greater tax benefit, such as those related to a business you own. These losses are considered “ordinary” and are deductible against your business (and other) income, while losses on investments are generally more limited.

In this case, the taxpayers, who operated a sole proprietorship as a diamond broker, purchased property in California in 1997 and built a house on it over the next five years. At the same time, the taxpayers purchased a house in Nevada, where they lived.

The California property was refinanced in 1999, and the taxpayers indicated on the loan documents and the Truth in Lending disclosures that they intended to live in the property. In 2000, when the loan was again refinanced, the taxpayers checked a box indicating they did not intend to live in the property.

In 2001, with the house still unfinished, the taxpayers hired a real estate agent and sold it for $4 million. They claimed a $1,377,325 ordinary loss on their 2001 tax return, and carried forward unused portions of the loss to 2002, 2003, and 2004.

The taxpayers say they intended to develop and sell the California property, and never intended to treat it as their personal residence, despite indicating on the loan papers that they did intend to do so. According to the architect/developer who built the home, developers often sign the loan documents stating the home will be used personally in order to receive more favorable loan terms.

The IRS says the disclosures on the signed loan documents show the taxpayers intended to live in the home. In addition, the IRS says the loss does not qualify as an ordinary business loss because the taxpayers were never licensed real estate brokers, they invested in only one other property (besides their home in Nevada) during the time the California property was being built, and they did not invest in any other property after the California property was sold.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 32KB)

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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.

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Right answer!
For the IRS. The taxpayers also purchased a personal residence around the same time of the purchase of the California property, and intended to live in it. The taxpayers did not intend to occupy the California property as a personal residence. In deciding whether the property was held for sale in the normal course of business, the court examined four factors: the nature of the acquisition, the frequency and continuity of sales, the nature and extent of the taxpayers’ business, and the activity of the seller. After analyzing the relevant factors and the specific facts of this case, the court did not find that the taxpayers held the California property in the ordinary course of a trade or business for sale to customers. Therefore, the loss realized from the sale of the property was a capital loss and not an ordinary loss. (Editorial Note: The court used only four of nine factors because of the relevancy of those four to the circuit court that will hear the appeal, if any.)
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