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Capital Gains - Introduction
Disclaimer and Warning - From Bob
Parrish CPA, P.C.
Capital Gains - Can IRS Challenge Real Estate Sales?
Your tax return may cause an unfavorable result, when seeking capital gains
The Tax Court in the case of Robert P. Walsh v. Cmmr. TC Memo 1994-293 (June 27, 1994) recently used a taxpayer's income tax return as a basis of disallowing capital gains treatment for property, which he contended was a capital asset.
The Tax Court held that the property was held primarily for sales to customers and therefore, an ordinary income item (39.6% rate) on his tax returns, rather than the more favorable capital gain (28% rate) treatment. The type of real estate and the purpose for which it is held will dictate the tax consequences on the disposition of the property. It may be difficult to determine whether the property is held for investment (a capital asset) or primarily for sale to customers (a noncapital asset).
The taxation of the sale of real property will depend upon the category
of real estate the property falls into. The following is a list of the
categories:
1. Property used in a trade or business. If the property was held for less than the required long term gain holding period the gain or loss is ordinary in nature. If held for the required long term holding period, the gain can be a capital gain and the loss can be either capital or ordinary.
2. Property held for investment. Any gain or loss is a capital gain or
loss.
3. Property held primarily for sale to customers. Any gain is ordinary
income and any loss is a fully deductible loss.
The issue of whether a sale to customers in the ordinary course of his
business is a question of fact. There is no one decisive test for
determining whether the property qualifies as held for sale in the usual
course of business. The answer depends upon an examination of all of the
facts.
The Supreme Court says that property is held "primarily" for sale to
customers when that is the principal purpose. It isn't sufficient if the
sale to customers is one of two or more alternative purposes. It must be
the chief purpose. In so holding the Supreme Court rejected the view
that if property is acquired for rental or other investment purpose but
the owner also plans to sell the property and realize gain in any way he
can if the original plan becomes unfeasible, then he holds the property
primarily for sale to customers in the ordinary course of his trade or
business. Malat, William v. Riddell, (1966, S Ct) 17 AFTR 2d 604, 383 US
569, 66-1 USTC, vacg & remg (1965, CA9) 15 AFTR 2d 1121, 347 F2d 23,
65-2 USTC.
The following three basic questions must be answered in determining whether realty was held for sale to customers in the ordinary course of business:
a. Was taxpayer engaged in a trade or business, and, if so, what business?
b. Was taxpayer holding the property primarily for sale in that business?
c. Were the sales contemplated by taxpayer "ordinary" in the course of that business?
In answering these questions the one court said the most important factor was the frequency and substantiality of sales. Development activities and solicitation and advertising efforts are relevant but less conclusive. Suburban Realty Co v. U.S., (1980, CA5) 45 AFTR 2d 80-1263, 615 F2d 171, 80-1 USTC, affg (1977, DC TX) 40 AFTR 2d 77-5387, 77-2 USTC, cert den (1980) 449 US 920 But other factors can overcome frequent and substantial sales, and the capital gain treatment was allowed even though taxpayer made 22 sales of real property over a three-year period. Taxpayer was not a licensed broker, did not advertise any of the properties for sale nor did he initiate their sale, did not maintain a separate real estate office, did not improve or develop the properties, and devoted only minimal time and effort to selling the properties. Byram, John v. U.S., (1983, CA5) 52 AFTR 2d 83-5142, 705 F2d 1418, 83-1 USTC.
The following factors, in addition to the three basic questions, have been emphasized by other courts in determining whether property was held for sale to customers in the ordinary course of business:
a. Nature and substantiality of the transactions;
b. Frequency, number and continuity of the sale;
c. Nature and extent of the improvements to the property to make it more
salable;
d. Nature and manner of acquiring the property;
e. Extent of promotional activities in making the sales;
f. Amount of profit realized from the sale;
g. Relation of income from real estate sales to total income;
h. Purpose for which the property was acquired;
i. Purpose for which the property was held;
j. Sales were accomplished through real estate brokers;
k. Time, attention, and effort, and the nature and extent of the sales
activities of taxpayers or their agents, in consummating the sales;
l. Business expense deductions were claimed relating to the sales of the
real estate;
m. Admissions were made on the taxpayer's tax returns;
n. Taxpayer had acquired adjacent land;
o. Taxpayer or his agents engaged in sales activity by developing and
improving the property.
In the Walsh case, the taxpayer initially owned thirty-five (35) acres
held by him for approximately 13 years. During the first few years, the
taxpayer subdivided the thirty-five (35) acre parcel for residential
purposes. A thirteen (13) acre portion of the thirty-five (35) acre
tract adjoining a busy highway was planned for a commercial center
sometime in the future, which he claimed to be held primarily for
investment. The taxpayer never had a comprehensive plan to develop the
thirteen acre (13) site, but only posted a "For Sale or Lease" sign on
it from 1981 to 1986. In addition, he placed six to eight ads in a local
paper from 1981 through 1986 for the sale of the property.
In 1986, the taxpayer was approached by a developer who offered to purchase the thirteen acres and subsequently agreed to the sale. He reported the gain as a capital gain. The key factor for the court was that the thirteen (13) acres were carried in the Walsh records as an inventory item, without any distinction as investment property. It was primarily his income tax return treatment of the property which led the taxpayer to his downfall.
Therefore, from a planning standpoint, you must be careful if you are contemplating in the future to sell inventory items, i.e., property primarily held for sales to customers, to make certain on your tax return that they are listed as an investment item, rather than an inventory item.
See Also "Basis"
Capital Gains (Changes in 1997-1998)
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Thursday, February 22, 2007 11:45 AM
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