Generally, when a person sells lots (vacant tracts of land) the gain from their sale is taxed as ordinary income despite the taxpayer’s holding period. The standard presumption is the property was held for sale to customers in the taxpayer’s ordinary course of business. In making this determination several factors are considered including:
(1) the taxpayer’s purpose in acquiring the property;
(2) the purpose for which the property was later held;
(3) the taxpayer’s everyday business and the relationship of the income from the property to his total income;
(4) the frequency, continuity, and substantiality of property sales;
(5) the extent of developing and improving the property to increase the sales;
(6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales;
(7) the use of a business office for the sale of property;
(8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property; and
(9) the time and effort the taxpayer habitually devoted to the sales. (David Taylor Enters., Inc. TC Memo 2005-127).
In a recent case the Tax Court has held that where a husband and wife purchased a parcel of property containing a number of lots to build a home and then sold the property they didn’t need, those excess lots were held for investment purposes and the proceeds of their sale resulted in capital gains and losses. The excess lots weren’t held primarily for sale to customers in the ordinary course of business and their sale didn’t result in ordinary income.
Facts. Bruce and Donna Rice purchased some 14.4 acres of undeveloped property in a desirable location near a preserve to build their dream home. The property was for sale as a unit. It wasn’t subdivided, and they couldn’t purchase only a portion of it. While they initially wished to keep the entire property for themselves, they eventually decided to sell the excess lots.
Other than sales of their own personal residences, the Rices had never engaged in the sale of real estate before (or since). They hired consultants for zoning, access, water and wastewater service, construction, and environmental issues. After they decided to subdivide the property, they hired a consultant to provide a subdivision layout and applied for and received a zoning change to subdivide and develop the property. They divided the property into ten smaller lots, reserving eight lots for homes and two lots for environmental purposes.
They sold all their lots through word of mouth rather than advertising. Their only advertising for the sale of the property was a wooden sign at the entrance to the subdivision. Among the eight lots suitable for construction, they eventually sold one lot in 2000, three lots in 2004, one lot in 2005, one lot in 2007, and one lot in 2008, and they held one in reserve for their daughter.
In 2004 the Rice’s reported their gain from the lot sales as capital gains and the IRS challenged their characterization contending that the lots were held primarily for sale to customers in their ordinary course of business. Happily for the Rices, the Tax Court found otherwise holding the Rice’s bought the property as an investment and not as property held for customers in the ordinary course of business. The gain from the sale of the excess lot was entitled to capital gains treatment.
In reaching this conclusion the Court found that even though Rices made significant improvements to develop and sell the excess lots, many of those improvements would have been necessary even if they hadn’t subdivided the property. The Rice’s advertising efforts were minimal, they sold primarily to friends and family and the number of lots sold was to small and infrequent to rise to a business status. Further, the Rices each held full time jobs and the proceeds from the sale of the lots was not invested in other real estate.
Thoughts. This decision is a great framework for when ordinary income versus capital gains treatment will apply when selling lots. As with most tax related issues it comes down to intent. Is it the taxpayers intent to buy and later sell the property for gain or is the intent to hold for investment. The sale of property purchased for investment does not change its character unless the taxpayers actions betray their intent e.g., immediately listing the property for sale or improving the property then selling. What investors should glean from this article is documenting your intent and actions can go along way in defining your intent if you happened to be audited in the future.
Posted by Clint Coons, asset protection attorney, Seattle, Washington