Real Estate “Dealer” – A Potential Scarlet Letter
Many practitioners assume the gain recognized from the sale of real estate will be taxed at capital gain rates. With the exception of selling a primary residence, this can be a hazardous assumption. Like virtually all property, gain realized from the sale of land generates certain tax consequences. Those consequences, i.e., the rate at which tax is assed, varies based on the taxpayer’s intent or reason for holding the land. If the taxpayer held land for investment purposes, any gain recognized upon its sale is taxed at favorable capital gains rate. Conversely, a taxpayer who is in the business of buying and selling land is taxed at ordinary income rates. A “dealer” is someone the IRS identifies as “in the business” of buying and selling real estate. A dealer holds land as inventory for federal tax purposes, which is, naturally, subject to ordinary income tax at sale.
What makes one a dealer in the eyes of the Internal Revenue Code? As with many U.S. income tax determinations, it’s complicated. Courts employ a rigorous factual analysis in determining if real property is held primarily for sale to customers in the ordinary course of a trade or business. California and some tax courts answer this question by analyzing five factors, none of which is dispositive. In this case, the taxpayer has an uphill battle; the IRS commissioner's determinations in a notice of deficiency are presumed correct, so the taxpayer bears the burden of proving that the land was held for investment by application of the five factors discussed below. In Pool, T.C. Memo. 2014-3, the Tax Court considered the five factors in determining that petitioner taxpayers improperly reported capital gain on the sale of land, which, the court ruled, was required to be classified as income on their partnership return.
Pool’s LLC, Concinnity LLC (“LLC”) purchased 300 acres of undeveloped land that was divided into four sections. The LLC sold three of sections to a development company, which was also owned by Pool. On its return, the LLC reported taxable income from these sales as a long-term capital gain. The IRS disallowed capital gain treatment, concluding that Concinnity was a dealer in real estate. As a dealer, in the hands of the LLC the land was treated as inventory, and not a capital asset. The gain the LLC recognized upon sale was therefore ordinary income, which was required to be reported on its member’s personal return.
1) Nature of Acquisition
Did the LLC intend to develop and sell the land at the time of purchase?
The IRS believed so, and cited the LLC’s 2000 tax return, which identified its principal business activity as “development,” and its principal product or service as “real estate.” The IRS also identified two statements in an affidavit the LLC filed in June 2001: (1) “Concinnity is the developer of proposed subdivision….and (2) “As of June 13, 2001, Concinnity has entered into buy-sell agreements for the sale of 81 lots...” . The Court stated this evidence was not conclusive, but held that the taxpayer failed to produce evidence sufficient to overcome its burden of proving it purchased property for investment purposes.
2) Frequency and Continuity of Sales
As a general rule, frequent and substantial sales of real property more likely indicate sales in the ordinary course of business, whereas infrequent sales for significant profits are more indicative of real property held as an investment.
In Pool, the LLC acquired a single parcel of land, which it subdivided into 81 separate parcels, but the court could not determine if all parcels were sold to one developer, or to 81 distinct customers. Again, the court held this factor weighed in favor of the IRS because the taxpayer failed to carry their burden.
3) Nature and Extent of Business
This factor essentially asks if the taxpayer was actively or passively engaged with the management or development of land.
Here, the LLC was directly engaged in making water and wastewater improvements on the property. The Court concluded, “this level of activity is more akin to a real estate developer's involvement in a development project than to an investor's increasing the value of his holdings. ”
4) Activity of the Seller About the Property
The taxpayer had the burden of showing that Concinnity did not spend large portions of its time actively participating in the sale of lots. As noted above, the Court was unclear if the LLC sought out 81 individual purchasers, or sold all lots to the related entity. Due to the uncertainty of involvement, the taxpayer failed to meet its burden of proving it did not spend large portions of time attempting to sell the property.
5) Extent and Substantiality of the Transaction
This is an elegant way of asking if the taxpayer’s primary motive was to defeat federal taxes otherwise owed.
The IRS argued the sale of land by the taxpayer to another company owned by the taxpayer should be disregarded. However, the court rebuffed the IRS, noting that transferring the property between the taxpayer’s entities could serve the legitimate business purpose of limiting liability from lawsuits.
One point for the taxpayer? No.
The court held that the sale did not appear to be conducted at arm’s-length because the property was sold at an inflated price, and the taxpayer failed to explain the substantial markup.
Shutout for the IRS. If that was not enough, the taxpayer was hit with a penalty for filing its income tax return five months late. But this is not always the case – if a taxpayer plans ahead (and understands its burden of proof), they can defeat the IRS and avoid being branded a “dealer.” More on that later.
— By Michael S. Cooper, Esq., Barnes Law
Michael Cooper is an associate attorney with Barnes Law, and is licensed to practice law in California.
The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.