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Land Is Not Always a Low-Taxed Capital Asset

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In one U.S. Tax Court decision involving several consolidated cases, the court concluded that gains from a partnership’s land sales were high-taxed ordinary income rather lower-taxed long-term capital gains. We’ll explain the decision, but first let’s cover some background information.

Capital Gains Tax Basics

Long-term gains recognized by individual taxpayers from the sale of capital gain assets are taxed at lower federal rates than ordinary income. Currently, 20% is the maximum federal income tax rate on net long-term capital gains from most capital assets held for more than one year. That ignores the possibility that the 3.8% Medicare surtax on net investment income might also apply.

For real estate, long-term gains attributable to depreciation are subject to a maximum federal rate of 25%, plus the Medicare surtax when applicable.

In contrast, the maximum federal rate on ordinary income is 39.6%, ignoring the possibility that the 0.9% additional Medicare tax on salary and self-employment income might also apply.

Key Point: Net short-term capital gains are taxed at the same high rates as ordinary income and are also potentially subject to the Medicare surtax.

Inventory Is Not a Capital Asset

These preferential tax rates only apply to long-term gains from dispositions of capital assets. These do not include property held by the taxpayer primarily for sale to customers in the ordinary course of business. Such assets are commonly called inventory. Whether property is inventory is a question of fact, but the Tax Court and the U.S. Circuit Court of Appeals for the 9th Circuit have identified the following five factors as relevant in making that determination:

  1. The nature of the acquisition of the property.
  2. The frequency and continuity of property sales by the taxpayer.
  3. The nature and the extent of the taxpayer’s business.
  4. Sales activities of the taxpayer with respect to the property.
  5. The extent and substantiality of the transaction in question.

The meaning behind these factors is certainly not self-evident. However, in one case, the Tax Court put them to use in deciding a real-life tax controversy.

Key Point: Taxpayers have the burden of proving that they fall on the right side of these factors. If they fail to do so, the IRS wins the point.

Facts Underlying the Tax Court Decision

Concinnity LLC (CL) was treated as a partnership for tax purposes. It was organized by three taxpayers, who also organized and incorporated Elk Grove Development Company (EGDC). CL acquired 300 undeveloped acres in Montana for $1.4 million. At the time of the purchase, the land was already divided into four sections (phases 1-4). The land later came to comprise the Elk Grove Planned Unit Development (Elk Grove PUD).

CL entered into an agreement that gave EGDC the exclusive right to purchase from CL phases 1-3, which consisted of 300 lots in the Elk Grove PUD. On its 2005 federal partnership return, CL reported $500,761 of long-term capital gains from two installment sales of the lots in phases 2 and 3. In turn, the three taxpayers (the owners of CL) reported their passed-through shares of CL’s gains as long-term capital gains on their respective 2005 individual federal income tax returns.

After an audit, the IRS claimed that CL’s land sales produced ordinary income rather than long-term capital gains and asserted tax deficiencies against the three owners.

The taxpayers took their cases to the Tax Court, where they claimed that the land sales produced long-term capital gains because the land was held for investment.

What the Tax Court Concluded

The Tax Court applied the factors listed above and found none weighed in favor of the taxpayers. Therefore, the court agreed with the IRS that CL’s land sale gains should have been reported as high-taxed ordinary income.

Factor No. 1: (Nature of Acquisition): The IRS claimed that CL acquired the land which came to be included in the Elk Grove PUD to divide and sell lots to customers. Supporting this position was the fact that CL’s 2000 partnership return identified its principal business activity as “development” and its principal product or service as “real estate.”

In addition, the Tax Court found that the record suggested that CL’s purpose in acquiring the land was to develop and sell it. Therefore, the court concluded that evaluation of this factor failed to show that the taxpayers held the property for investment rather than as inventory for sale to customers.

Factor No. 2: (Frequency and Continuity of Sales): The Tax Court observed that frequent and substantial sales of real property indicate sales of inventory in the ordinary course of business, whereas infrequent sales for significant profits are more indicative of property held for investment. In this case, the record was not clear as to the frequency and substantiality of CL’s land sales.

The court noted that CL’s tax returns reflected two land sales in phases 2 and 3 to EGDC and an affidavit stated that CL had directly entered into agreements for the sale of 81 lots in phase 1, without the involvement of EGDC. However, the record was insufficient to establish the overall extent of CL’s sales activities. Therefore, the Tax Court concluded that evaluation of this factor failed to show that the taxpayers’ sales were not frequent and substantial.

Factor No. 3: (Nature and Extent of Business): With regard to this factor, the IRS claimed that the only documents in the record indicated that CL brokered the land sale deals, found additional investors for the development project, secured water and wastewater systems, and guaranteed that necessary improvements were made.

The Tax Court agreed that the record showed that CL paid for certain water and wastewater improvements to the Elk Grove PUD and that this level of activity was more akin to a developer’s degree of involvement than to an investor’s action to increase the value of the property. The court concluded that evaluation of this factor failed to show that CL held Elk Grove PUD land primarily for investment rather than as inventory for sale in the ordinary course of business.

Factor No. 4: (Sales Activities with Respect to the Property): The record was unclear as to whether CL sought out the 81 individual phase 1 lot buyers or whether the buyers sought out CL. Therefore, the Tax Court concluded that evaluation of this factor failed to show that CL did not spend large portions of its time actively participating in selling lots in the Elk Grove PUD.

Factor No. 5: (Extent and Substantiality of Transaction): EGDC agreed to buy the land in question from CL at an apparently inflated price. According to the Tax Court, this indicated that CL did not make bona fide arm’s-length sales to EGDC, which was also owned by the taxpayers.

This tended to indicate that EGDC was formed for tax avoidance reasons: to buy the lots from CL and then sell them to customers in order to avoid the appearance that CL was itself in the business of selling lots to customers. Therefore, the court concluded the taxpayers were on the wrong side of this factor.

Bottom Line

Because the taxpayers in this case were not found to be on the right side of any of the five factors, the Tax Court agreed with the IRS that CL held the Elk Grove PUD lots as inventory for sale to customers in the ordinary course of business. Therefore, CL’s land sales generated high-taxed ordinary income rather than lower-tax long-term capital gains. (Cordell Pool, et al, T.C. Memo 2014-3)

With more careful attention to detail, CL’s land sale profits could have been properly characterized as lower-taxed long-term capital gains. However to achieve this favorable result, CL’s activities should have been limited to acquiring the property and subsequently making just a few sales to the development entity EGDC. Unfortunately, the taxpayers failed to prove that:

  1. CL did not do any significant development work itself; and
  2. CL was not itself involved in selling lots to customers.

So the IRS won. If you have questions or want more information on tax planning for land sales, consult your tax adviser.