Is your real estate held for sale in the ordinary course of business, or is it an investment? Real estate investors rarely address this question but failure to understand the distinction can result in significant taxes, penalties, and interest. This was exactly the issue in SI Boo LLC et al. v. Commissioner; T.C. Memo. 2015-19; Nos. 174-11, 199-11, 459-11 wherein the tax court considered whether the real estate investor’s activity amounted to an active trade or business resulting in higher income taxes for the investor.
Real estate investor purchased numerous tax liens in Illinois over a two-year period. Several of the liens acquired by investor were not redeemed. Following the proper legal procedure, investor acquired the tax deed to the properties and in turn sold the properties to third parties. Over the period, investor sold 157 properties of which 90 were held for less than one year and 23 on installment sale.
Investor reported all of the income from the sale of the properties as either short-term or long-term capital gains depending on how long the property was held before sale with the installments sale income recognized over the term of the contract.
IRS and Tax Court’s Position
The service audited investor to recharacterize investor’s income as ordinary income from property held primarily for sale to customers in the ordinary course of investor’s trade or business i.e., no long or short term capital gain treatment. Further, the Service sought to make the income subject to self-employment taxes and disallow the installment sale deferral method. The tax court, after considering the IRS’s position, came to the same conclusion based upon the following analysis:
Whether property is held primarily for sale to customers in the ordinary course of a taxpayer’s trade or business is a question of fact which must be determined by consideration of all the surrounding circumstances. See Guardian Indus. Corp. & Subs. v. Commissioner, 97 T.C. at 316; Pritchett v. Commissioner, 63 T.C. 149, 162 (1974). Generally, to determine the purpose for which property is primarily held courts look to the taxpayer’s purpose at the time the property was sold although courts can consider events that occurred before that time in order to identify that purpose. See Taiyo Hawaii Co., Ltd. v. Commissioner, 108 T.C. 590, 612 (1997); Guardian Indus. Corp. & Subs. v. Commissioner, 97 T.C. at 316. In determining the taxpayer’s holding purpose, more weight is given to objective evidence than the taxpayer’s own statements of intent. See Guardian Indus. Corp. & Subs. v. Commissioner, 97 T.C. at 316; Daugherty v. Commissioner, 78 T.C. 623, 630 (1982).
Courts consider numerous factors when deciding the taxpayer’s primary purpose for holding property. See Major Realty Corp. & Subs. v. Commissioner, 749 F.2d 1483, 1488 (11th Cir.1985 … The factors include: (1) the frequency and regularity of sales of real properties; (2) the substantiality of the sales and the relative amounts of income taxpayers derived from their regular business and the sales of real properties; (3) the length of time the taxpayers held the real properties; (4) the nature and extent of the taxpayers’ business and the relationship of the real properties to that business; (5) the purpose for which the taxpayers acquired and held the real properties before sale; (6) the extent of the taxpayers’ efforts to sell the property by advertising or otherwise; and (7) any improvements the taxpayers made to the real properties. See Sovereign v. Commissioner, 281 F.2d at 833; Guardian Indus. Corp. & Subs. v. Commissioner, 97 T.C. at 317. After applying the factors we consider relevant for disposition of these cases, we find that the entities acquired and held the real properties primarily for sale to customers in the ordinary course of their trades or businesses.
Based upon these factors court concluded the investor engaged in the trade or business of real estate. In sum, the entities’ sales of real properties were frequent and regular during the years at issue. See, e.g., Garrison v. Commissioner, T.C. Memo. 2010-261 (holding that amounts received from 15 real property sales during a three-year period constituted ordinary income); Clayton v. Commissioner, T.C. Memo. 1956-21 (holding that amounts received from 17 real property sales during a four-year period constituted ordinary income), aff’d, 245 F.2d 238 (6th Cir. 1957).
Impact on Investors
The problem in this case could have easily been avoided if the investor elected to run their business as a S-Corporation or Limited Partnership versus a LLC. Many attorneys and some CPAs do not appreciate the impact on an investor who runs his active real estate business through an LLC disregarded or treated as a partnership for federal tax purposes. In each instance, the member of the LLC is treated as a sole proprietor thus, the activity of the entity is attributed directly to the member. Using a S-Corporation or limited partnership breaks this link and the income attributed to the owner is ordinary income not subject to self-employment taxes (except for salary payments). In this case, if the investor had used a different business form he would have avoided the substantial self-employment tax and by adding a second entity for the long-term holds, possibly maintained this favorable tax treatment.
A potentially larger concern is for those investors who engage in similar activities in their self directed IRAs or pension plans. Although this tax court case dealt with a LLC it nevertheless illustrates how the IRS might view similar activity in either of these plans. The net result of an IRA or pension classified as engaging in a trade or business will result in a tax rate of 40% plus an additional 25% penalty if not paid in the year the tax is due.
As I have indicated in my previous posts, the IRS is hunting real estate investors. Despite the lurking threat, there are steps you can take to minimize your risk. Contact my office to set up a consultation if you would like some assistance in these matters.