Category: Individuals; Real Estate
Subject: Real Estate Dealer Status
Title: Taxpayer Stroke as Evidence of Change of Intent to Hold Property for Sale to Customers
IRC Sections: 1221
Filename: 1316.html
Date Produced: 05/94

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Taxpayers are husband and wife formerly residents of the U.S. Virgin Islands until their move to the U.S. in 1990. Husband was engaged in the business of constructing swimming pools in the U.S.V.I. Husband suffered a severe stroke in 1989 leaving him severely disabled. Taxpayers own four properties in the U.S.V.I.

Property 1
Property 1 consists of an office building purchased (or constructed) in 1988. The taxpayer intended to set up an office in this building and to lease the balance of the building to tenants. After the taxpayer's stroke in 1989, the plans were abandoned. The building has been vacant since its purchase.

Property 2
Property 2 consists of 30 acres of land purchased in 1982 for investment. A portion of Property 2 was used for storage of supplies and equipment related to the taxpayer's pool business.

Property 3
Property 3 consists of a large tract of land which the taxpayer subdivided into 110 lots, 100 of which have been sold. The most recent sales occurred in 1991 (3 lots) and 1990 (13 lots).

Property 4
Property 4 consists of a tract of land divided into 6 lots. The taxpayer purchased the property with the intention of building a personal home on one or more of the lots. The property had already been subdivided when it was purchased by the taxpayer. After the taxpayer's stroke, plans to build a residence on this property were abandoned. Sales with respect to this property are as follows: 1 lot in 1984, 1 lot in 1985, 1 lot in 1987, and 1 lot in 1993.

Issue
The issue is whether there is support for the position that the taxpayer's severe stroke in 1989 gave rise to a fundamental change of intent with respect to any or all of these properties such that the taxpayers would no longer be considered to be in the trade or business of selling real estate, and the income from such sales would be taxed at capital gains rates and not be subject to self-employment tax.

Answer
There is some support in the case law for the capital gain/non-trade or business position with respect to Properties 1,2, and 4. The pro-taxpayer argument with respect to Properties 1 and 2 appears to be fairly strong. There is little or no support for a pro-taxpayer argument for Property 3, and while there is a significant pro-taxpayer argument with respect to Property 4, there is considerable risk inherent in the position.

Discussion
Whether the taxpayer is deemed to be in the trade or business of selling real estate is essentially a question of fact to be determined based on all the facts and circumstances surrounding the case. The decision turns largely on the taxpayer's intent with respect to each property at issue. In essence, does the taxpayer intend to hold a given property for investment or does the taxpayer intend to hold the property for sale to customers in the ordinary course of business? The determination must be made on a property-by-property basis; thus, a taxpayer can be considered a dealer with respect to certain properties and an investor with respect to others. See, for example, Harbour Properties, 32 TCM 580.

It is clear that a taxpayer's intent with respect to a given property can change over time. Whether the taxpayer's intent has changed is a question of fact, and the taxpayer bears the burden of proving that his intent has in fact changed. There is a significant body of case law on this issue, and the least that can be said about these cases is the courts have held taxpayers to a very high standard when it comes to proving a change of intent particularly when the intent changed from development to holding for investment. There is no case sufficiently on point to clearly support the position the taxpayers want to take in this matter. Conspicuously absent in the body of relevant case law is any case in which the taxpayer developed property into lots, underwent some significant change of circumstances, continued to sell off the lots, and the issue before the court was whether capital gains treatment was available as a result of the change of circumstances.

The successful change of intent cases by-and-large deal with taxpayers who purchased land for development and subsequently sold off the land, in bulk, due to failure to get proper financing or zoning or because the intent to develop the project was abandoned due to some demonstrable event such as imminent condemnation of the property. See Washington Realty Co., 62-2 USTC ¶9748; Loans and Service, Inc. 61-1 USTC ¶9356; H.B. Morrison, 79-2 USTC ¶9587; W.A. Scheuber, 20 TCM 235; Sproul Realty, 38 TC 844. Ridgewood Land Company, Inc., 31 TCM 39.

The closest case to the taxpayer's facts seems to be Ralph W. Simmers, Inc. 27 TCM 739. The taxpayer in the case was a construction company. After the death of its principal shareholder, the company was operated the shareholder's son. Sometime later, the son formed his own development company which purchased some of the construction equipment from the company as well as some of the land that had been acquired for development by the company. At the time of the sale, all equipment of the company was gone, and it was clear that there was no longer any intention to develop anything further in this company. Capital gain was allowed on the sale.

With respect to the facts at hand, I offer the following observations.

1. It would seem to me that a very strong factual case could be developed as to investment intent with respect to the office building and the 30 acre tract. Based on the facts as I understand them, there was never any intent to do anything with these properties except hold them for appreciation and/or long-term production of rental income. There is a demonstrable event, the taxpayer's change of health, that prevented the realization of the plans to rent the office building. The failure to rent the building certainly should not taint the taxpayer's intent particularly given the length of time the building has been held.

2. It seems to me that having developed Property 3, the 110 lot parcel, in such a way as to so clearly indicate holding for sale in the ordinary course and further having reported at least 16 sales (and probably more) as dealer sales after the taxpayer's stroke, there is little chance of success with respect to a change of intent on this property.

3. Property 4, the exclusive parcel of six lots, seems the most promising. First, the taxpayer's primary motive for buying this property was in connection with construction of his own personal residence. These plans were abandoned as a result of the taxpayer's illness. Second, the taxpayer did not subdivide the property himself. It was already subdivided when he bought it. Third, the taxpayer's expenditures with respect to improvement of this property were not large. Fourth, the taxpayer's sales with respect to this property were sporadic.

The risk factors with respect to this property are as follows. First, the taxpayer has treated previous sales as dealer sales; however, this treatment pre-dates the taxpayer's illness. (I understand that the 1993 return has not been filed.) The degree of the taxpayer's sales activities with respect to this property is an unknown. The higher the degree of active selling, the higher the risk factor. You should inquire carefully as to this matter with the taxpayer.