It’s easy, in the course of investing in real estate, to forget that there’s a difference between property being bought and sold in the normal course of affairs and property that’s strictly being held for investment. But failing to understand this question can cost you in terms of significant taxes, penalties, and interest charges.
Such was the case in SI Boo LLC et al. v. Commissioner; T.C. Memo. 2015-19; Nos. 174-11, 199-11, 459-11. In this instance, the court undertook the question of active trade and higher taxes for the investor in question.
In this case, an investor purchased numerous tax liens in Illinois over a two-year period. Several of these liens were never redeemed. So, following proper legal guidelines, the investor acquired each property’s tax deed and then sold the properties to third-party investors. Some 157 properties went through this process; the investor held 90 of them for less than a year and sold 23 of them on an installment basis. The investor then reported all income from the property sales as either short- or long-term capital gains — depending on how long he had held the property beforehand.
The IRS Position
When the IRS audited the investor, they recharacterized the income as “ordinary” income from property held primarily for resale, in the course of the investor’s normal trade or business operations, and nullified the capital-gain treatments. The IRS went even further, however, claiming that the income was subject to self-employment tax, and disallowing the installment-sale deferral methods.
What the Tax Court Decided
Unfortunately for the investor, the tax court came to a decision in favor of the IRS’s positions:
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.
In other words, in the court’s (and the IRS’s) opinion, whether the investor saw himself as engaged in the “trade or business” of real estate, he was judged, in fact, to be in precisely that position.
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).
How Could This Have Been Avoided?
The dilemma has a fairly simple solution: the investor runs his property transactions through an S-Corporation or Limited Partnership, versus an LLC. Surprisingly enough, many attorneys don’t appreciate the potential costs to a client who runs his active real estate business through an LLC; in each instance, the member of the LLC is treated as a sole proprietor. When framed as such, the activity of the LLC is actually attributed directly to an individual member.
However, using an S-Corporation or limited partnership dissolves that link. Once this happens, then, income attributed to the owner is ordinary income not subject to self-employment taxes (except for salary payments). In the example we mention above, a different business form would have enabled the investor not only to avoid self-employment tax but — by adding a second entity for long-term holds — possibly even maintained a favorable tax status.
…And Just When You Thought Retirement Funds Were Safe…
If you’re presently engaged in similar investment activities through a self-directed IRA or pension plan, be forewarned: the aforementioned view and decision by the tax court regarding LLCs can easily carry over into similar IRS treatment of income in either of these types of plans, too. And that treatment can be very costly, indeed: an IRA or pension classified as engaging in a trade or business can result in your being taxed at 40 percent, plus an additional 25 percent penalty for late payments past the tax year when they’re due. Those substantial income “bites” are hits few of us can truly afford…and none of us truly wants.
Protecting Yourself during IRS “Open Season”
We’ve frequently warned investors that the IRS is “hunting” them — apparently (and unfortunately) with some degree of success. But there are things we can do to help minimize your risks and protect your assets. So contact us for reliable information, realistic plans, and answers to your concerns…BEFORE you’re in the IRS and tax court crosshairs!