 |
 |
 |
 |
 |
 |
 |
 |
 |
There is a classification difference between property held primarily for sale to customers (dealer) and property held for investment purposes. While property held for investment purposes generally is taxed as capital gains for tax purposes, dealer property is generally taxed at ordinary income rates. The favorable capital gain tax treatment can amount to substantial tax savings when large dollar amounts are involved with the sale of property. Moreover, it is generally more favorable to be taxed as an investor when property is sold than to be taxed as a dealer.
The courts have described the classification of real estate as an issue in the determination whether the seller taxpayer is to be deemed as a dealer or non-dealer. A dealer in real estate may have greater difficulty than a non-dealer in establishing an investment purpose for holding the property.
In addition to being denied capital gain treatment on the sale of property, taxpayers that are dealers are denied favorable tax treatment for both the deferral of gains through use of the installment method of income reporting and the tax free I.R.C. §1031 property exchange treatment rules. Accordingly, dealers are denied the benefits of using the installment rules under I.R.C. §453(b)(2)(A) and tax free property exchange treatment under I.R.C. §1031. Not being afforded the benefits of deferring gains under the installment rules can lead to serious problems for the taxpayer not entirely related to paying a higher tax rate. In this situation, it is possible for the taxpayer to owe more tax than the proceeds collected under the installment agreement
There is an exception to this general rule of capital gain treatment, however, where real property used in a trade or business that is not a capital asset, may still qualify for capital gain treatment on the sale of such property under I.R.C. §1231. Under §1231, when real estate is sold at a gain that qualifies under this section, the gain is treated as capital gain regardless if the reason for holding the property is of a business purposes or an investment purpose. Either way, capital gain treatment will apply.
A “dealer” is defined in the Blacks Law dictionary as a person who purchases goods or property for sale to others; a retailer.
A “dealer disposition” of property is defined in section 453(I)(1)(B) of the Internal Revenue Code as any disposition of property held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business. Moreover, a “dealer” is prohibited from using the installment method for reporting sales or other dispositions made after 1987. The specific facts of each case will determine whether a taxpayer is holding such property as a dealer for sale to customers or as an investment.
Additionally, a capital asset is not property held by dealers, therefore, dealers cannot enjoy the benefit of capital gain treatment on the sale of both personal and real property unless the property falls under an exception to the rule under I.R.C. §1231.
The Internal Revenue Code defines a capital asset under I.R.C. §1221(a), a capital asset is “…property held by the taxpayer…, but does not include…property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business….”
The term “primarily for sale to customers” is an essential term that courts have used to determine if the taxpayer will be deemed to be a dealer concerning the sale of property.
The Supreme Court settled the dispute of the definition of the term “Primarily” in Malat v. Riddell, 383 US 569 (1966). In the Malat case, the court held that, as used in §1221(1), “primarily” means “of first importance” or “principally.” In Malat, the court held that despite the taxpayer selling properties as a dealer and recognizing ordinary income from those dealer sales, the taxpayer also held properties as an investor and should recognize capital gains from those non dealer sales. The property was not held primarily for sale to customers, and the status of being a dealer does not poison all the sales, causing all the taxpayer’s gains to be ordinary income.
Moreover, a real estate dealer, or a person in the active conduct of the business of selling property, may still acquire and sell parcels of land as long term investments. When he does, he is entitled to be treated as an investor and to have capital gains treatment of his profit. Scheuber v. Commissioner, 371 F.2d 996 (7th Cir. 1967).
The key focal point is the purpose of the acquisition and the purpose for holding the property; was the purpose “primarily” for the sale to customers.
Sometimes, dependent on the factors of each case, dealer status may be determined by the conduct of the taxpayer. When real property held as an investment is subdivided and sold, dealer status may be imposed on the taxpayer by operation of law. Generally, courts have created a seven factor test to analyze the taxpayers circumstances to decide whether the taxpayer is in the active conduct of a trade or business, thereby imposing dealer status on the sales of the property. See Dr Builder Article
In United States v. Winthrop, 417 F.2d 905,69-2 USTC P9686 (5th Cir. 1969), the court held that these seven factors should be used to evaluate the taxpayers conduct: 1) The nature and purpose of the acquisition of the property and the duration of ownership; 2) Extent and nature of the taxpayers efforts to sell the property; 3) Number, extent, continuity, and substantiality of the sales ; 4) Extent of subdividing, developing and advertising to increase sales; 5) Use of a business office to sell the property; 6) The time and effort the taxpayer habitually devoted to the sales; 7) Character and degree of supervision or control the exercised by taxpayer over the individual selling the property.
If enough of the factors are present, then the taxpayer is deemed to be carrying on a trade or business and is not entitled to capital gain treatment from the property sales. This could impose serious tax consequences on the taxpayer, causing a higher tax to be paid on the proceeds.
However, the Federal Ninth Circuit, created the exception of “liquidation intent” to the general rule of ordinary income recognition. The seller’s intent to liquidate the property may be sufficient to escape ordinary income determination despite the fact that significant improvements were made to the properties and substantial selling activities were conducted by the taxpayer. This is true even though the improvements created a significant increase in the valuation of the property.
In Heller Trust v. Commissioner, 382 F.2d 675 (9th Cir. 1967), the court created an expansive liquidation exception where the taxpayer decided to liquidate his investment, stating: “if a taxpayer held certain property as an investment, and…this purpose continued until shortly before the time of sale, and …the sale is prompted by a liquidation intent, the taxpayer should not lose the benefits provided by the capital gain provisions.”
In Heller Trust, the taxpayer decided to liquidate an apartment complex he owned due to his failing health. The taxpayer made substantial improvements to the property by converting the apartments to condominiums, hired a sales staff, opened a model unit and a sales office, and extensively advertised the sales of the condos. Despite all of these commercial activities, the court held that the sales were not made in the ordinary course of a trade or business, and allowed the taxpayer to realize capital gains on the condo sales.
The Ninth Circuit’s liquidation exception was again demonstrated in Gangi v. Commissioner, 54 T.C.M. 1048 (1988), where the Tax court held, citing the Heller Trust case, that despite significant improvements and substantial selling activities, the gain was capital gain due to the liquidation intent of the taxpayer.
In the Gangi case, the taxpayers formed a partnership to build a 36 unit apartment complex intending to hold the property for the production of rental income. After operating the apartments for eight years, the partnership was dissolved and the apartments were converted into condos with the intent of liquidating the investment. Substantial improvements were made in the conversion process that increased the value of the complex by 30%. A sales model was constructed, offices were set up, sales brochures were printed, and significant advertising was conducted to facilitate the sales. The court held that the gain from the sales qualified for capital gains treatment because the property was not held primarily for sale in the ordinary course of a trade or business.
Despite all of the commercial sales activities in both the Heller Trust and Gangi cases, the courts held that the sales qualified for capital gain treatment because such property had been held for investment purposes for many years and did not give any weight for the purpose of holding the property at the time of sale. The sales were determined to be capital gains.
I.R.C. §1237 provides a statutory safe harbor for real property tracts, subdivided for sale, and held by other than c-corporations or dealers. If the conditions of the statute are met, and there is no other substantial evidence that the taxpayer holds the real estate primarily for sale to customers in the ordinary course of his business, he shall not be considered a real estate dealer holding the property primarily for sale, merely because he has: 1) subdivided the tract into lots and 2) engaged in advertising, promotion, selling activities or the use of sales agents in the connection of such sales of the lots in such subdivision. Such subdividing and selling activities shall be disregarded in determining the purpose for which the taxpayer held real property sold from the subdivision. Accordingly, under the protection of §1237, the taxpayer will not have dealer status imputed upon him because he satisfied the dealer factors under the Winthrop case.
For §1237 to apply, the taxpayer must hold the property for five years prior to the sale unless the property was inherited, and not have made substantial improvements to the property prior to the sale.
Upon satisfying the §1237 requirements, the gains from the sale of the parcels are capital gains up to the fifth parcel being sold. In the same tax year that the sixth parcel is sold within the same tract of land, a five percent ordinary income requirement is imposed for all the sales within that tax year. Moreover, if five parcels are sold in a tax year, all the gains are capital gains. If a sixth parcel is sold in December, all the sales for that year are subject to the five percent ordinary income rule, the rest of the gains are capital gains. The five parcel rule applies to each parcel or tract of land individually, therefore, ten sales of ten parcels on two separate tracts can be made without invoking the five percent ordinary income rule. The five parcel rule is also attached to the five year rule in that five parcels could be sold and then five years later, another five parcels could be sold within the same tract of land and all the sales would still be capital gains.
The five year holding period applies to property the taxpayer holds individually, jointly, or as a member of a partnership. The taxpayer is not, however, considered holding property owned by members of his family, held by an estate or trust, or held by a corporation, Reg§1.1237-1(b)(3). Inherited property does not include property acquired by a surviving joint tenant or by a surviving spouse in a community property state.
Substantial improvements are defined within Reg §1.1237-1(C)(4) as such that the value of the tract of property is increased by ten percent. The definition of “substantial improvements prior to sale” concerning the timing of the improvements, also includes improvements made to the property pursuant to a contract of sale with the buyer. Moreover, the property cannot be sold on contract and then subsequently improved pursuant to the same contract.
There is an exception to the substantial improvement rule for property held by the taxpayer for ten years, not allowing for the inheritance exception described in the five year test. Here, the substantial improvements must be necessary to make the tract of land marketable and an election must be made not to include the cost of the improvements in the basis of the tracts of land or deduct the cost as an expense, Reg §1.1237-1(c)(5)(iii).
An installment sale is a method were the gains from the sale of property can be deferred as the payments are collected on an installment basis from the original sale. I.R.C. §453(b)(2)(A) states, however, that dealer dispositions do not qualify for installment sale treatment. A dealer disposition is defined in I.R.C. §453(I)(1) as personal or real property held by the taxpayer for sale to customers in the ordinary course of business.
The primary risk in using the installment sale method of deferring gains is that the I.R.S. may be effective in reclassifying the taxpayer as a dealer, thereby causing all the gains from the sale to be immediately taxable to the taxpayer.
It is possible for a taxpayer to be a dealer and not know it until he or she is notified of a determination by the I.R.S. In Wang v. Commissioner, 27 T.C.M. 2087 (1998), an investor that retired from IBM and started buying and selling commercial real estate full time was deemed by the court to be a dealer and not entitled to use the installment method to defer the income recognition from the property sales. He was forced to recognize all the gains from his property sales in the year he sold the property.
A dealer selling timeshares or residential lots can make an election, however, to use the installment method for such sales under I.R.C. §453(I)(2)(B). The dealer must pay interest on the deferred tax liability under I.R.C. §453(I)(3), which is dependent on the payments to be received in the years after the year of the initial sale.
There is another trap under I.R.C.§453A, applicable to taxpayers selling investment property as non-dealers under the installment method with an aggregate value exceeding five million dollars within a tax year. In this case, he will be forced to pay interest on the deferred tax liability which would negate the benefits of the favorable capital gain rates by adding an interest cost to the sales.
Although there is an exception for farming operations, the definition of ‘farming” is interpreted strictly. In Tom v. US, 283 F.3d 939 (8th Cir. 2002), the court held that a farm implement dealer did not qualify for the farming exception because it was not a true farming operation and the deferral of gains from the sales of such equipment was denied under the installment rules.
I.R.C. §1031 states that property exchanged that had been held by the taxpayer as property available for sale to customers, does not qualify for 1031 tax free exchange treatment. Property that is held available for sale to customers is dealer property. Therefore, dealers may not take advantage of deferring gain under the like kind exchange provisions. The statute was upheld in Regals Realty Co. v. Commissioner, 29 AFTR 444 (1942), where the court found that property held available for sale to customers does not qualify for tax free exchange treatment under I.R.C. §1031.
Suppose that a taxpayer holds appreciated property that he wants to develop to increase his potential profits when the developed property is subsequently sold. What if instead of developing and selling the property himself, then taking the risk of being deemed a dealer, the taxpayer sells the property to a controlled corporation and then has the corporation develop and sell the property. In this situation, the sale of the property to a controlled corporation will allow the taxpayer to extract the capital gains from the property and realize the ordinary income that remains as a shareholder of the corporation when the property is developed and subsequently sold. The taxpayer in substance, has converted some of the gains he may have recognized as ordinary income as a dealer from the sales to capital gains.
The I.R.S. has two main legal theories which they use to deny capital gain treatment is such cases. First, the transaction is claimed to be in substance a contribution of capital because of thin capitalization or a tax free transaction under I.R.C.§351. Under the §351 position, the Service claims that the debt issued by the corporation is actually a “security” and is being exchanged for property by the corporation. Secondly, they claim that the property is already dealer property before the transaction takes place.
The IRS fought this tax planning technique in Bradshaw v. US, 683 F.2d 365 (Ct. Cl. 1982), however, the Court held in this landmark case that the transfer was a sale because:
1) The sales price reflected the FMV, and the sale was fair and reasonable.
2) The fact that the sale was between a corporation and its shareholder does not, by itself, support the characterization of a contribution to capital. Shareholder may contract with its controlled corporation as long as the transaction is fair and reasonable.
3) The notes were negotiable instruments and contained an unqualified obligation to pay the principal amount with a fixed maturity date. The notes were legitimate.
4) The mere fact that a corporation is not thinly capitalized does not, per se, control the character of the transaction. Undercapitalization is not a determining issue for the determination of the gain recognized from the property sale.
5) The notes were not securities under the definition of section 351.
6) The transfer of the notes were not a sale or exchange of securities under section 1232(a)(1). Reg §1.453-9(c)(3) says the character of the gain is the same as the transferred property.
Many years prior to the Bradshaw case, the 4th Circuit Court of Appeals overruled the Tax Court in Albert Turner v. Commissioner, 540 F.2d 1249 (4th Cir. 1976). The court held that where the taxpayer purchased real property, held it for 4 years and subsequently sold it to a controlled corporation for FMV, the gain from the initial sale was capital gain. Turner sold the property to the controlled corporation with the intent to have the corporation develop the land. The Turner court relied on some of the same factors that were later mentioned in the Bradshaw case, such as 1) a sale at fair market value took place and 2) the sale was fair, reasonable and appeared to be at arms length.
Ten years after the Bradshaw case, the Tax Court was overruled again, but this time in the 5th Circuit, in Bramblett v. Commissioner, 960 F.2d 526 (5th Cir. 1992). In Bramblett, the taxpayers, who owned a partnership, caused the partnership to sell undeveloped land to a controlled corporation. The corporation subsequently developed and sold the property. The tax court argued that the partnership’s sale of the property was ordinary income because it was just an extension of the corporation, and that the partnership was in fact a dealer The appellate court disagreed with both points, stating that the sale was for fair market value, was a legitimate sale between two entities, and that the partnership was not a dealer.
It appears that when using a controlled corporation to develop the property, care should be given not to allow the conduct of the taxpayer to cause the court to declare him as a dealer before the property is sold to the corporation.
There are certain limited situations where dealer status may be desirable. These situations usually apply to losses. If you have a loss, it is preferable to have the deduction against ordinary income. The main reason for this is that capital losses on the corporate level can only offset capital gains and the remainder is carried over to other years. Capital losses on the individual level is limited to $3,000 per year. You may not live long enough to be able to use up your capital gains, and at the corporate level, they disappear forever after five years.