Category: Real Estate Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer (TP) is involved in purchasing, rehabilitating, and reselling single family dwellings. TP sold 3 properties in 1992, 4 properties in 1993, and anticipates selling 3 or 4 properties in 1994. TP anticipates continuing this practice. Thus far, the sales have been treated as capital gains and reported on Schedule D. The issue is the degree to which the taxpayer is exposed to a reclassification of the rehabilitation activity as a trade or business rather than an investment activity. Based on my research, it seems to me that there is a very high degree of exposure with respect to TP's activities. §1221(1) denies capital gain treatment with respect to sales of property held primarily for sale to customers in the ordinary course of business. Neither the statute nor its legislative history offer any clues as to the specific meaning of the operative phrase "property held primarily for sale to customers in the ordinary course of business", and the massive body of existing case law in this area provides few, if any, bright-line standards on which the taxpayer can safely rely. This situation led the Fifth Circuit Court of Appeals to remark that it found itself "engulfed in a fog of decisions with gossamer-like distinctions, and a quagmire of unworkable, unreliable, and often irrelevant tests..." U.S. v. Winthrop, 417 F.2d 905, 906 (5th Cir. 1969). Whether property is held primarily for sale to customers in the ordinary course of his trade or business is a factual question. While no single factor or test is dispositive, the factors considered by the courts in determining whether a taxpayer is in the business of selling real property include: (1) the purpose for which the property was acquired; (2) the purpose for which the property was held; (3) the extent and substantiality of improvements made by the taxpayer in relation to either the fair market value of the property or the taxpayer's acquisition cost; (4) the timing and purpose of improvements made; (5) the frequency, number, continuity, and substantiality of sales; (6) the nature and extent of the taxpayer's business; (7) the extent of such activities as advertising to promote sales and attract purchasers; and (8) the listing of the property for sale directly or through brokers and the activities of the seller or those acting in his behalf with respect to actual disposition of the land. The courts have consistently held that no single factor is controlling in any given case. Biedenharn Realty Co., Inc. v. U.S., 526 F.2d 409 (5th Cir. 1976). In addition, each case must stand entirely on its own facts and circumstances. The courts have held that the fact that an earlier case reached one conclusion on a given set of facts is not necessarily indicative of a similar result by the same or another court on essentially the same facts. Scheuber v. Comr., 371 F.2d 996 (7th Cir. 1967). However, it is possible to glean from the many court decisions certain patterns, and these patterns represent the only means at our disposal of attempting to "predict" how any given set of facts and circumstances would ultimately be viewed. Clearly, reliable predictions are absolutely impossible. The patterns in the existing cases merely allow what amounts to educated guessing. The existence of a pattern of selling property is an extremely strong indicator that the taxpayer is engaged in the trade or business of selling real estate. The Fifth Circuit has indicated that frequency of sales is the most important determining factor. Biedenharn Realty Co., Inc. v. U.S., 526 F.2d 409 (5th Cir. 1976), cert. denied, 429 U.S. 819 (1976). In fact, in the case of Suburban Realty Co. v. U.S., 615 F.2d 171 (5th Cir. 1980), cert. denied, 449 U.S. 920 (1980), the court found the property in question to be held by the taxpayer for sale to customers in the ordinary course of business solely based on the factor of sales frequency. It seems to me that in TP's case, a clear pattern of frequent sales has been established. While it is true that the number of units sold is not high in absolute terms, TP has undeniably established a pattern of selling property on a regular basis. Closely related to the concepts of frequency and patterns of sales is that of acquisition of replacement property. If the taxpayer acquires replacement property, that is an indication that the taxpayer is in the real estate business and is not passively holding property in order to enjoy whatever appreciation there may be. See Huey v. U.S., 504 F.2d 1388 (Ct. Cl. 1974) and Gartrell v. U.S., 619 F.2d 1150 (6th Cir. 1980). It seems to me that TP is engaging in the practice of acquiring replacements for the properties sold. The existence of development activity on the part of the taxpayer is a very strong indicator of sales to customers in the ordinary course of business. Courts in various circuits have held that the presence of development activity in conjunction with frequent and regular sales is normally dispositive of the matter in favor of ordinary income treatment. See Biedenharn Realty Co., Inc. v. U.S., 526 F.2d 409 (5th Cir. 1976), cert. denied, 429 U.S. 819 (1976), Achong v. Comr., 246 F.2d 445 (9th Cir. 1957), and Gault v. Comr., 332 F.2d 94 (2d Cir. 1964). In TP's case, there is considerable development activity. As I understand it, TP purchases single family dwellings and then invests considerable time, effort, and money rehabilitating the properties for resale. As I understand it, these activities go far beyond ordinary repair and fixing-up activities in which a passive investor might engage in order to maximize his investment. It seems to me that this substantial development activity, particularly in conjunction with a pattern of sales, is an extremely strong indicator of sales to customers in the ordinary course of business. The foregoing represents a discussion of some of the major factors used by the courts to determine whether a taxpayer is holding property for sale to customers in the ordinary course of business. There are a number of other factors which were set forth at the outset of this memorandum. It is my view that these other factors also weigh against TP's position. 1. TP's properties were acquired and held, as I understand it, specifically for the purpose of development for resale in a short period of time. This acquisition and holding purpose is diametrically opposed to the purpose of holding a property for passive appreciation. 2. Although not specifically addressed in the facts, it is presumably the case that TP's business activities with respect to these properties are substantial and active. Also, it is presumably the case that once properties are completed, TP actively markets them either through her own efforts or through the efforts of brokers or sales agents. These factors are also highly indicative of a taxpayer in the trade or business of selling real estate. It seems to me that the mere presence of substantial development activity in TP's case could alone be sufficient to tip the scales in favor of ordinary income treatment for TP's activities. Development activity is the exact opposite of the type of holding purpose and the activities which produce capital gain in the real estate context. Taken in conjunction with the wealth of other negative factors--sales frequency and regularity, purchase of replacement property, acquisition and holding of properties for short-term resale, and the presumed existence of substantial and active business activity with respect to the properties--it seems to me that there is an extremely high degree of exposure that TP's activities would be classified as sales of property to customers in the ordinary course of business. |
