Is the Sale of Real Property Ordinary Income or Capital Gain?

Editor: Michael D. Koppel, CPA/CITP/PFS, MSA, MBA

Gross Income

The question of whether a sale of real property produces capital gain or ordinary income is a matter of tax law interpretation. The taxpayer’s intentions and actions in each situation need to be examined to determine if the taxpayer is in the business of selling real property to customers, which would cause the transactions to be subject to ordinary income taxes as opposed to the more favorable capital gains rates.

The recent case of Flood, T.C. Memo. 2012-243, illustrates this issue. There are other issues in this case, but this item focuses on the classification of income from the sale of real property.

The facts of the case are straightforward. During the time in question, Donald Flood was a day trader in the stock market. He and his wife also were active in real estate activities that consisted of purchasing and reselling vacant lots. In general, the Floods did not make any improvements to the land they purchased. Between 2001 and 2008, the Floods purchased approximately 250 lots. They sold 2 lots in 2004 and 40 lots in 2005. In 2005, they donated 11 lots to the Sawyer Road Baptist Church. In 2004 and 2005, the Floods had profits, which they reported on Schedule D as capital gain. The IRS reclassified the gain as business income that should have been reported on Schedule C and taxed at ordinary income rates. The IRS also determined that the Floods were subject to self-employment tax on the income.

In determining whether the income should be classified as ordinary income or capital gain, the court evaluated nine criteria: (1) the taxpayer’s purpose in acquiring the property; (2) the purpose for which the property was subsequently held; (3) the taxpayer’s everyday business and the relationship of the income from the property to the taxpayer’s total income; (4) the frequency, continuity, and substantiality of sales of property; (5) the extent of developing and improving the property to increase sales revenue; (6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales; (7) the use of a business office for the sale of property; (8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property; and (9) the time and effort the taxpayer habitually devoted to sales of property. It is important to note that, under Sec. 1221(a)(1), property is not a capital asset if it is “stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer . . . or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

During the trial, Mr. Flood argued that the lots were purchased for investment purposes and therefore the profits should be taxed as capital gains. However, the court found that even though the Floods did not develop the lots or use a business office, they put considerable effort into the real estate. The Floods examined public records to determine which property owners to contact to purchase the lots, mailed letters to the property owners to facilitate their purchase of the lots, prepared agreements for execution, prepared deeds, paid legal fees to clear title to properties they purchased, paid legal fees to ensure the closing of the properties, paid legal fees to enforce specific performance of purchase-and-sale agreements, conducted research, made phone calls, and used a real estate agent to sell lots. Additionally, Mr. Flood created a website designed to sell the lots and place advertisements in public places. The court also considered that the income the Floods derived from other sources was modest compared with the sale of the lots.

The court concluded that the “preponderance of credible evidence supports a conclusion that the Floods’ real-estate transactions were conducted in the ordinary course of a trade or business and not for investment purposes.”

Determining whether a real estate sale produces ordinary income or capital gain is difficult and is potentially an issue that can cause a taxpayer to be liable for significantly higher taxes. Unfortunately, as this case demonstrates, there is no bright-line test. Further, while the Tax Court identified the specific tests, it is still unclear how many of those tests have to be passed for a transaction to be treated as capital.

EditorNotes

Michael Koppel is with Gray, Gray & Gray LLP in Westwood, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.