Actions taken throughout the life cycle of a real property investment determine how it is held.
Actions taken throughout the life cycle of a real property investment determine how it is held.
Real estate deemed held for investment is subject to favorable capital gain tax rates.
Real estate treated as dealer property is subject to less-favorable ordinary income tax rates.
It is important to be proactive when determining dealer versus investor status.
Title owners of real property need to be aware that various actions taken with regard to real property may affect whether a gain or loss on the sale of the property is capital or ordinary in nature. The actions (or inactions) taken throughout the life cycle of a real property investment determine whether specific real estate is held for investment or held as dealer property. Real estate deemed held for investment is subject to favorable capital gain tax rates, while real estate treated as dealer property is subject to less-favorable ordinary income tax rates. In addition to facing higher tax rates on dispositions of property, dealers in real property are precluded from using tax-deferral strategies such as installment sale treatment under section 453 and like-kind exchange treatment under section 1031.
The issue of dealer versus investor classification has been frequently litigated. Because the federal tax code and regulations do not provide clear guidelines, taxpayers and their advisors must wade through numerous judicial interpretations involving a wide range of differing facts and circumstances in order to make a determination as to the appropriate classification. In general, the case law looks to five main factors in determining the proper classification of a taxpayer as either a dealer or an investor.
As explained more fully below, a recent Tax Court case, Cordell D. Pool v. Commissioner of Internal Revenue, T.C. Memo 2014-3 (2014), provides a refresher course on the five main factors. It also serves as a reminder that taxpayers and their advisors need to analyze all the specific facts and circumstances, document the known facts and the representations relied upon, and ensure all tax return filings reflect the appropriate status. The taxpayer bears the burden of proof in any dispute with the IRS.
The five factors as explained in the Pool decision are briefly discussed below:
Frequent and continual sales of various parcels of real property may indicate that such sales are undertaken in the ordinary course of business, while infrequent sales, often for significant profits, are more indicative of real property held as an investment. In Biedenharn Realty Co. v. United States, 526 F.2d 409 (5th Cir. 1976), the frequency and substantiality of sales were analyzed as the two most important criteria in determining dealer status.
In Suburban Realty Co v. United States, 615 F.2d 171 (5th Cir. 1980), a corporation held large volumes of land it had received from its shareholders. The corporation then sold more than 240 separate parcels to different buyers over a period of 33 years. The corporation engaged in no solicitation, advertising, development activity or subdivision activity, and did not act as a broker. Despite other facts that would typically suggest capital gain treatment, the court found that the continuous sales activity by the corporation over 33 years and the large number of discrete sales (240 over a 33-year period) were overriding factors compelling the conclusion that the corporation was selling its land parcels as a dealer in the ordinary course of business.
By contrast, the Tax Court in Buono v. Commissioner, 74 T.C. 187 1980, concluded that the taxpayer was entitled to capital gain treatment upon a single sale of land, despite the fact that the taxpayer was involved in activities related to zoning and subdivision. Buono acquired undeveloped land with the intention of subdividing the property into smaller lots to increase the property's value and promptly selling the property once it secured municipal approval of the subdivision. In Buono, the court reasoned that although the taxpayer was involved in subdividing and zoning activities, the land was disposed of in a single asset sale and should accordingly be treated as investment property eligible for capital gain treatment. The court reasoned that the taxpayer did not engage in frequent sales, did not make any improvements to the land, and engaged in the subdivision merely to make the land more marketable for sale by the party to whom it sold the subdivided tract. It should be noted that Buono was able to prove its intention from the beginning was to sell the land to a single buyer.
If a taxpayer's activities with regard to a tract of land include subdividing, grading, zoning, or installing roads and utilities, the taxpayer may be deemed a dealer due to the nature of the development activity performed. It should be noted that this factor should be studied in relation to the particular parcel or tract of land involved. The mere fact that the owner of an investment parcel is also engaged in development activities with respect to other parcels should not be relevant to the tax treatment of a parcel genuinely held for investment.
The courts closely study the specific facts and circumstances in a case where there is some level of improvement and development to real property in relation to the other four factors.
Some cases in this area have allowed capital gain treatment despite a high level of development activity, and in other cases, mere zoning activities have tainted the property to be dealer property.
In Pritchett v. Commissioner, 63 T.C. 149 (1974), the taxpayer was in the business of developing real estate and acquired a particular parcel of property that he intended to hold for investment. On prior-year returns, the taxpayer recognized ordinary income on the sale of real estate that he held for development (parcels he subdivided and developed). In this case, the IRS argued the gain on the sale of the parcels that Pritchett claimed were held for investment should also be recognized as ordinary income, similar to the treatment of the parcels he sold in the past. The court found in favor of Pritchett and allowed capital gain treatment on the property because Pritchett made no effort to subdivide or improve the property and the property was sold after he received an unsolicited offer from a third party.
It should also be noted that it is helpful to show the segregation of investment and dealer properties when multiple types of properties are held in an entity. Segregating into separate accounts and reflecting this on the financial statements and supporting documentation can help to lead to successful outcomes in court. The surrounding facts for the various parcels must also support the dealer and investor categorizations. There are several cases in which segregation is discussed including Robert P. Walsh T.C. Memo 1994-293 and Boree v. Commissioner 2016-2 U.S.T.C.
Another important factor to explore in the determination of investor versus dealer status is the extent of the taxpayer's sales and marketing effort related to the disposition of a particular parcel of real estate. If the taxpayer advertises, markets, solicits customers, or merely lists the property for sale, it is more likely that there will be ordinary treatment on an ultimate sale.
In Biedenharn Realty Co. v. United States, 526 F.2d 409 (5th Cir. 1976), cert. denied, 429 U.S. 819, the court denied capital gain treatment to a taxpayer who acquired land with the original intent to hold for investment. Although there were some other negative factors (some development and frequent sales), the court spent considerable time focusing on the taxpayer's solicitation and advertising efforts. The court noted the amount of signage used for marketing purposes as an important factor in concluding that the taxpayer was a dealer, not an investor. Furthermore, the court noted that the use of an independent broker to solicit sales does not shield a taxpayer from being treated as a dealer. This case is similar to others where a taxpayer may have some factors suggesting ordinary income, but the extent of the taxpayer's sales and marketing activities is the nail that seals the coffin, requiring dealer treatment.
The overall level of the taxpayer's real estate activities, with a particular focus on the extent to which the taxpayer's main occupation is developing property for sales to customers in its ordinary line of business, also factors into the dealer versus investor determination. Questions the courts have examined include whether the taxpayer owns or operates a related construction, development or brokerage business; whether the taxpayer has performed similar activities on other parcels of real property; how many parcels and sales the taxpayer has been involved with in the past; whether the taxpayer has a full-time occupation other than real estate; and whether the taxpayer has a history of syndicating buy-and-hold real estate investment vehicles for investors.
Finally, courts have extensively analyzed the taxpayer's intent in acquiring and holding the property. The ultimate questions are “why did the taxpayer buy the real property in the first place?” and “for what purpose was the property held at the time of sale?”
In Moore v. Commissioner, 30 T.C. 1306 (1958), taxpayers acquired property by gift and liquidated the tract of land by selling 22 lots over an 11-year period. The court in Moore found in favor of the taxpayer and allowed capital gain treatment. The Tax Court noted that one may liquidate an asset in the most advantageous way and still obtain capital gain treatment. The real question is whether, at the time of sale, the property is held merely for liquidation or whether the owner has entered into the business of holding property primarily for sale to customers in the ordinary course of the business. In Moore, the taxpayer's method of disposal was chosen merely to maximize proceeds. The court found that the intent was never anything other than to receive the maximum proceeds on sale—intent consistent with investor treatment. Further supportive facts were that the taxpayer did not engage in extensive development or sales activities during the 11 years of sales.
Courts have also found that a taxpayer's intent may change. Then, the relevant question is the purpose for which the property was held at the time of its sale. In Nevin v. Commissioner, T.C. Memo 1965–53 (1965), parcels of real estate that were not yet platted were deemed investment property at the time of sale. However, income from sales of parcels that were platted with streets installed before the sale was deemed ordinary. The court in Nevin noted that “when a rapid turnover occurs under the circumstances … and the taxpayer is in the real estate business and originally acquired the property for resale, it stretches the imagination to conclude that the land was held for investment at the time of sale.” The taxpayer in Nevin treated everything as held for investment, but the court deemed that some plots were held for investment and some were held as dealer property.
It is possible for a taxpayer to acquire a large tract of real property, break it into sections, and upon the sale bifurcate the treatment so as to receive capital gain for some plots and ordinary income for others. In Westchester Development Inc. v. Commissioner, 63 T.C. 198 (1974), the sales of tracts that were subdivided by the taxpayer to sell as sites for construction of single-family homes were sales within the ordinary course of the taxpayer's business. However, sales of tracts that had not been subdivided or marketed resulted in capital gain. In such a case, it is generally advisable to separate the plots into separate entities to ensure that one parcel's status does not taint the status of another parcel. It is also important to ensure partnership agreements, investor letters, tax returns and other documents properly reflect language that corresponds to the taxpayer's intent in holding the property.
More recently, in Boree v. Commissioner, U.S.T.C. 2016-2, a developer with inventory was not successfully able to defend a change in circumstances from dealer to investor property even though there were certain restrictions to the development of the developer’s property. In this case, the taxpayer sold several lots and treated the lot sales as dealer property. According to the taxpayer, there was then a change in facts and there were substantial restrictions placed on the property after which the taxpayer abandoned all efforts to develop and sell in the ordinary course of business. Then, in the final year, the taxpayer sold in one bulk sale the remaining lots. Ultimately the tax court found that, while there were restrictions imposed, those restrictions did not deprive a landowner of all potential uses of the property. In fact, the taxpayer still took action after that point to create a planned development strategy. Additionally, there was nothing that the taxpayer had as evidence that the investment property was segregated from other properties held for sale. Taxpayers should be cognizant that it is difficult to prove change in intent when going from dealer to investor status.
The dealer versus investor analysis became even more complex in 2013 with the enactment of the net investment income tax under section 1411. Although it is beyond the scope of this article, practitioners should consider the interplay between a dealer or investor classification and the treatment of the property under section 1411.
It is important to be proactive in the consideration of the various factors that the courts have referenced in determining dealer versus investor status. Decisions and actions that occur early in the acquisition phase of real estate investments can have far-reaching implications for the taxability of real estate investments. Taxpayers should consult with their tax advisors to determine the most appropriate classification status—dealer or investor.