Tax Considerations for Gain or Loss in Real Property Sales

Posted on 11.16.16

Tax Considerations for Gain or Loss in Real Property Sales

By Amanda Mills, CPA, Senior Tax Manager | Real Estate & Construction Industry Team

Gain or loss realized upon the sale of real property is treated as either capital or ordinary based upon a review of facts and circumstances. It is important to properly categorize the property due to the varying levels of tax rates associated with a sale. Ordinary income producing property is taxed at marginal rates between 10%-39.60% for the 2016 tax year whereas long-term capital gain property is taxed at lower, more favorable rates ranging between 0%-20% (2016 tax year). Capital gain property held for less than one year is not eligible for the preferential rates previously mentioned but is rather taxed at the same marginal rate as the taxpayer’s other ordinary income. Higher income taxpayers may also be subject to the additional 3.8% Medicare surtax. Because of the difference in tax rates and the need to examine the details of each transaction, the tax classification and related tax treatment for real property transactions has often been a topic for debate between taxpayers and the Tax Court over the years.

In a recent court case, Boree v. Comm., the Tax Court determined that the gain from the sale of land was ordinary income despite the taxpayer’s argument that it was held as an investment. Upon purchase of the vacant land, the taxpayer began a series of planned residential developments and asserts that he abandoned his original intent to develop the property once the County imposed mandatory paving requirements rendering the overall project futile. As a result, the taxpayer contends that the “unimproved” property was held for investment at the time of the sale and was therefore subject to the lower capital gains tax rate. The Court disagreed with the taxpayer and concluded that the land was not investment property but rather held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.

To qualify for the preferential rate on capital gains realized, the property sold must be a capital asset in the hands of the taxpayer and must be held for at least one year and a day. A capital asset is defined as “property held by the taxpayer (whether or not connected with his trade or business) but does not include….property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business…”. The Court considered several factors in determining whether or not the land was indeed a capital asset or was actually held for sale in the ordinary course of business.

The Fifth Circuit enumerated a list of factors to be considered when determining whether property is a capital asset including “(1) the nature and purpose of the acquisition of the property and the duration of the ownership; (2) the extent and nature of the taxpayer’s efforts to sell the property; (3) the number, extent, continuity and substantiality of the sales; (4) the extent of subdividing, developing, and advertising to increase sales; (5) the use of a business office for the sale of the property; (6) the character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and (7) the time and effort the taxpayer habitually devoted to sale.” On the contrary, factors considered in determining whether or not property was held for sale in the ordinary course of business included “(1) whether the taxpayer was engaged in trade or business, and if so, what business; (2) whether the taxpayer was holding the property primarily for sale in that trade or business; and (3) whether the sales contemplated by the taxpayer were ‘ordinary’ in the course of that business.”

Although no factor or combination of factors is controlling, more emphasis is placed upon the frequency and substantiality of sales which generally indicates that the property is held for sale while the absence of sales efforts ordinarily speaks in favor of investment. In this instance, the Court analyzed the taxpayer’s sales over a ten-year period. Prior to the bulk sale in question, the taxpayer sold “approximately sixty lots comprising approximately 600 acres and over one-third of the property”, engaged in no other income producing activity, and reported lot sales each year as ordinary business income. Despite the decrease in the number of sales after the paving requirements were imposed, individuals continued to acquire lots even though they were deed executions that the taxpayer held as security from previous sales. Based on these observations, the Court deemed that the taxpayer’s activity rose to a level of frequent and substantial sales.

Furthermore, the Court also examined the taxpayer’s intent and continuous development activities spanning over several years. The Court agreed that the taxpayer’s original purpose for acquiring the land was for investment; however, as noted above, the taxpayer engaged in such frequent and substantial sales over multiple years that his intent changed at some point and the property became available for sale. Upon acquisition, the taxpayer immediately began subdividing and selling lots and seeking approval for multiple phases of development identifying himself as the developer of the project. Even after the County imposed the paving requirements, the taxpayer continued to pursue development activities by trying to obtain exceptions to the paving requirements and applying for the property to be rezoned.  Because of the taxpayer’s continuous efforts to move forward with the project, the Court found that his intent and actions qualified the property as being held for sale and the gain on the bulk land was subject to ordinary income tax rates.

There is no one decisive test in determining whether or not an asset qualifies as capital or held for sale in the ordinary course of business. The answer depends upon an analysis of all of the facts. Therefore, careful planning should be taken with regard to any transaction that includes real property prior to executing the deal.

For more information on this topic, or if you have any other questions on the tax treatment of gain realized upon the sale of real property, please consult your opportunity advisor at Keiter or Email | 804.747.0000

Sources: RIA Checkpoint, Boree v. Comm.