Real property losses are capital, not ordinary

By Merrick Shawe, CPA, Irvine, Calif.

Editor: Mark G. Cook, CPA, CGMA

In Musselwhite, T.C. Memo. 2022-57, the Tax Court held that a taxpayer’s losses from the sale of four lots (real property) were ordinary in nature, as opposed to capital.

In this case, William Musselwhite, a personal injury attorney, in 2012 was distributed real property from his passthrough entity, DS & EM Investments LLC. Less than four months later, Musselwhite sold the lots at a loss.

DS & EM’s principal business activity was reported on its partnership returns as investment. In years where there was activity from the sale of real property, the amounts were reported on Schedule D, Capital Gains and Losses, attached to Form 1065, U.S. Return of Partnership Income. From the company’s inception in 2005 to 2011, real property that was capitalized on Schedule L, Balance Sheets per Books, and subsequently sold was classified by the taxpayer as “other investments” and not as inventory. The real property that was classified as other investments had characteristics similar to the real property at issue that, beginning in 2011, was classified as inventory. No amended returns were filed to correct the classification of these lots for the years prior to 2011. Regarding the lots designated as inventory, although improvements were made to them up until 2009 and a development plan was in place, the plan was ultimately discarded, and no improvements took place from 2009 on.

To determine whether the taxpayer’s classification and treatment were correct, the Tax Court looked to Sec. 1221(a)(1). Under Sec. 1221(a)(1), a capital asset does not include “stock in trade of the taxpayer or other property of a kind that 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.” The term “primarily” as used here has been defined by the Supreme Court to mean “of first importance” or “principally” (Malat v. Riddell, 383 U.S. 569, 572 (1966)), and the burden of proof lies with the taxpayer. The court used the following factors formulated in Graves, 867 F.2d 199 (4th Cir. 1989), by the Fourth Circuit, to which this case would ordinarily be appealable, to determine whether the taxpayer held the property “primarily for sale to customers”:

  1. The purpose for which the property was acquired;

  2. The purpose for which the property was held;

  3. Improvements, and their extent, made to the property by the taxpayer;

  4. The frequency, number, and continuity of sales;

  5. The extent and substantiality of the transaction;

  6. The nature and extent of the taxpayer’s business;

  7. The extent of advertising or lack thereof; and

  8. The listing of the property for sale directly or through a broker.

Factors 1 and 2 were considered by the Tax Court in tandem. The court held that at the time of the property distribution in 2012, the purpose for which the property was acquired and held was investment. This was evidenced at trial by testimony of the taxpayer, who stated that the activity within the partnership was “really investment.” Additionally, no progress was being made or even attempted to develop the properties for eventual sale, further convincing the court that the property was held for investment purposes.

The lack of development of the lots during the brief time Musselwhite held them caused the court to likewise find that factor 3 favored the government.

As for factors 4 and 5, the only properties that DS & EM sold were reported as capital in nature; after the property distribution from DS & EM to the taxpayer, the one sale of real property was the only real estate sales activity engaged in by the taxpayer.

Factor 6 examines the broader picture of the taxpayer’s financial activities and sources of income. As indicated earlier, the taxpayer was a personal injury attorney. He consistently reported that the majority of his income was from his legal business, which the Tax Court said indicated that development and sale of real estate was not his everyday business.

Factors 7 and 8 weighed for the taxpayer and against the government, the court held, noting evidence indicating that, immediately after receiving the lots, Musselwhite hired a real estate broker to aggressively market and sell them.

However, with the “overwhelming weight” of the remaining six factors against the taxpayer and for the government, the four lots were not Musselwhite’s inventory, stock in trade, or property held primarily for sale to customers in the ordinary course of business under Sec. 1221(a)(1). They were instead capital assets, the court held.

What could a taxpayer in similar circumstances do differently to have the best chance possible of being able to claim an ordinary loss for real property held as inventory? A taxpayer could keep detailed records of the amount of time spent preparing properties for sale. Another option may be to set up an alternative entity with a different principal business activity description that would handle sales. All of this is to say that, to alter the outcome, the inputs need to be altered. The IRS looks at taxpayers’ facts and circumstances, so, logically, taxpayers need to be mindful of the limitations of those facts and surrounding circumstances.

Editor Notes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif. For additional information about these items, contact Mr. Cook at 949-623-0478 or Contributors are members of or associated with SingerLewak LLP.

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