By: Nathan Smith, CPA, Senior Manager at Blue & Co.
“You can’t have it both ways” is a sentence many CPAs may have expressed to their clients at one time or another over the course of a tax accountant’s career. For example, a real estate client that segregates and writes off a significant portion of their building purchase as personal property, but prefers to argue all the personal property vanished when selling it a few years later in order to sidestep significant ordinary income recapture (rather than Internal Revenue Code (“IRC”) Section 1231 gain taxed at a preferential rate).
IRC Section 1231: A Rare Exception
Speaking of IRC Section 1231, this may be one of the few areas that the IRS does give some leeway in the “having it both ways” department. IRC Section 1231 gain includes gain from the sale of certain depreciable business property if it has been held over one year. In these cases, if an individual realizes a gain, the IRS will generally allow them to pay tax at a long-term capital gains rate (with a bit higher, but still preferential, rate provided if the gain is due to depreciation recapture). If an individual has a loss, the IRS will allow you offset business ordinary income. This is beneficial since taking capital losses is typically limited to the amount of capital gains, plus $1,500 to $3,000 per year depending on marital status, whereas ordinary losses can offset all manner of income.
Case Study: Musselwhite vs. The IRS
Notwithstanding, the IRS typically will not allow you to have it both ways. Case in point most recently involves whether a taxpayer was a real estate dealer or investor in Musselwhite, T.C. Memo 2022-57. The taxpayer was a full-time practicing attorney who one can surmise had a bit of disposable income in the mid-1980s and decided to form a partnership with some family members to acquire and develop land. After some litigation that came about from the housing crisis of 2008, it would appear much of the real estate acquired over the years that still remained in the partnership was worth quite a bit less than originally paid.
From 2008 to 2011 the partnership that held the real estate listed lots as “Investment – Real Estate” on Schedule L, Balance Sheet of their partnership tax return. From 2011 and 2012, the partnership moved the lots to the “inventories” line of the partnership tax return. In 2012 Musselwhite was distributed his share of the partnership real estate from the partnership to himself personally, which ultimately amounted to a condo and four lots. Musselwhite made no further improvements on the lots from 2008 to 2011.
In 2012 Musselwhite was able to sell the lots, but at a substantial loss. Musselwhite represented that he was a dealer in real estate, rather than an investor, and, accordingly, listed the sales on his Schedule C, Profit or Loss from Business, which allowed him to report the sales as ordinary sales of real estate inventory and offset those losses against his ordinary income as an attorney. One of the kickers here is that when times were good (likely most lot sales made prior to the housing crisis), the original partnership’s gross sales of similar lots were reflected on Schedule D, Capital Gains and Losses. As well, the principal business had been traditionally listed as “Real Estate Investment” on annual reports filed with the state.
Thus, the taxpayer in this case was attempting to have it both ways, gains are capital and carry a preferential rate, whereas losses are ordinary, are not limited to capital gains, and can offset other ordinary income. As you might have guessed, the IRS took issue with him on this position.
How the IRS Determines Dealer vs. Investor Status
IRC section 1221(a) notes that a capital asset does not include “inventory or property held by the taxpayer primarily for sale to customers in the ordinary course of the trade or business”. Real estate not used in a trade or business, and instead typically held for investment, is considered a capital asset. However, if the sale of real estate is an integral part of a taxpayer’s business (i.e. the taxpayer is a dealer in real property), rather than simply being held for investment or speculation, the sale will produce ordinary income.
In good times tax savings can be substantial when sales are treated as capital due to preferential capital gains rates as well as the ability to use the installment method. The installment method can defer and report the gain over time as payments are received. This method is generally not available for a “dealer” sale of real estate.
Generally speaking, to determine if a taxpayer is a dealer in real property (rather than just an investor), the taxpayer must have a trade or business for which real estate is held primarily for sale in that business, and any sales generated must be in the ordinary course of that business. As with all things IRS, the determination of investor versus dealer in real property is based on the “facts and circumstances”.
Ralph S. Norris, T.C. Memo 1986-151, considered the following facts and circumstances:
- Nature and purpose for which the property is acquired;
- extent of improvements and advertising to increase sales;
- number, frequency, and substantiality of sales;
- duration of ownership;
- continuity of activity related to sales over a period of time;
- extent and nature of the efforts to sell the property;
- extent of subdividing and development to increase sales;
- use of a business office for the sale of the property; and
- character and degree of supervision or control over representatives selling the property.
Lessons Learned and Best Practices
The court found in the Ralph S. Norris case that the taxpayer’s real estate activities were his only source of income and that he expended “significant time, effort, and money” on improvements and renovations of his properties. The court ruled that the taxpayer was in the business of buying and selling real estate and his real estate assets were not capital assets.
Contrasting this with the Musselwhite case discussed above, the court looked at eight factors, most of which followed similar facts and circumstances enumerated above in the Ralph S. Norris case. The court found that Musselwhite’s properties lacked real estate development activity, the properties were previously classified as investments on the balance sheet, and previous sales of real properties were reported on Schedule D as capital assets. The court held that the sale of these lots appeared to be more of an isolated transaction rather than a frequent sale of real estate activity. Finally, Musselwhite’s everyday business activity was as a full-time attorney and not the activity of buying and selling real estate as was the situation in the Ralph S. Norris case.
It should be noted that the court did point out two factors that Musselwhite did demonstrate that favored real estate dealer treatment. This included that a broker was secured to help sell the lots, and the broker attested that she put in substantial amounts of time and effort into marketing the lots. In the end, however, the court found the preponderance of facts of circumstances weighed against Musselwhite’s assertion that he was a dealer in real estate. Thus, the sales should have been treated as a sale of property held for investment on Schedule D. This means that Musselwhite may have a long time to wait, in the absence of other significant capital gains, to utilize the capital losses generated on the lot sales. As noted above, individual taxpayers are only allowed to net $1,500 to $3,000 (depending on marital status) of net capital losses per year against their ordinary income.
The key takeaway here is that Musselwhite attempted, ultimately unsuccessfully, to have it both ways with the IRS. A taxpayer cannot argue that similar gains are capital and losses are ordinary. As such, it cannot be understated how important the facts and circumstances are in the determination of whether a taxpayer is a dealer in real estate or a real estate investor, and the effects that determination will have on income, expenses, gains, and losses generated from that taxpayer’s real estate activities.
Please reach out to your local Blue & Co. advisor today if you have any questions on being a dealer or investor in real estate.
