Real Estate Held For Sale To Customers?

This is a pretty dry post (and reads more like a tax law exam), but it's a common issue for taxpayer's that sell real estate.

Mr. & Mrs. Rice bought 14.4 acres for $300,000 in Austin, Texas. Their initial intent was to keep the entire 14.4 acres and build their dream home. Ultimately, they decided to subdivide the property into ten lots. They spent considerable effort subdividing the land, including rezoning, water and sewage, etc.

Afterward they built themselves a 12,000 square foot house (4,000 of which was for garage and porches) on the most desirable lot, and commenced selling the remaining lots. The first lot was sold in 2000 to friends. In 2002 they posted a wooden sign advertising lots for sale. the The next sale did not occur until 2004, at which time the Rice's sold three lots. Two of the lots were sold at a loss to relatives, and one was sold at a gain to friends. The remaining lots were sold in 2005, 2007, and 2008 to friends and acquaintances.

The issue for the Tax Court was whether the gain(loss) from the lots sold in 2004 should be ordinary or capital. When this issue arises the taxpayer usually argues for capital treatment if there is a gain and ordinary if their is a loss. The reason is that capital gains are taxed at lower rates than ordinary gains. Alternatively, capital losses are limited, while ordinary losses can be used to offset other earned income. Here, the Rice's have both a gain and a loss, but they were arguing for ordinary treatment (probably because their losses exceed their gains).

To receive ordinary treatment, taxpayer's must "hold the property primarily for sale to customers in the ordinary course of business." If, however, the taxpayer holds the property for investment, then gains(losses) from sales receive capital treatment.

The law in this area is well settled, though the application of facts to the law is anybody's guess. The governing section is 1221, but the courts have developed a seven factor test to determine whether the taxpayer held the property primarily for sale . . . quoted straight from the 5th Circuit in U.S. v. Winthrop:

1. The nature and purpose of the acquisition of the property and duration of ownership
2. The extent and nature of the taxpayer's efforts to sell the property
3. The number, extent, continuity and substantiality of the sales
4. The extent of the subdividing, developing, and advertising to increase sales
5. The use of a business office for the sale of the property
6. The character and degree of supervision or control exercised by the taxpayer over any representative selling the property
7. The time and effort the taxpayer habitually devoted to the sale.

Unfortunately for the Rice's their intent and efforts did not rise to the level of a business, thus there losses and gains are capital not ordinary. The Tax Court primarily considered their lack of effort to sell the lots coupled with the infrequency of sales.

Considering this was all going on during the real-estate boom, and in a thriving city like Austin, the Rice's did not have much of an argument. With the right amount of effort they probably could have sold all the lots in 18-24 months and made a substantial gain. Of course, then they would be arguing for capital gain treatment and the IRS would have argued they were in a business!

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The issue for the Tax Court was whether the gain(loss) from the lots sold in 2004 should be ordinary or capital. When this issue arises the taxpayer usually argues for capital treatment if there is a gain and ordinary if their is a loss.