Land Sales, Taxpayer Considered a Dealer or Investor
By Nick Finkenauer, CPA
When land is sold, long-term capital gain rates are often assumed. While these rates may apply to the majority of sales, recent decisions from the Tax Court and a California District court are good reminders that land may not always be a capital asset. The court decisions were based on five factors to determine the appropriate tax rate for the gain on sale of land. These factors focus not only on the circumstances leading up to the sale, but also the seller’s intent during the acquisition of the property. The five factors are as follows:
- Analyze the nature of the acquisition. Was the land initially purchased for investment or development? At that time, were the taxpayer’s primary service and/or principal product “real estate”?
- Assess the frequency and continuity of property sales by the taxpayer. Is the taxpayer often involved with land sales indicating that the land is more like inventory than an investment?
- Consider the nature and extent of the taxpayer’s business. Were the taxpayer’s actions to increase the land’s value more like that of a developer or an investor?
- Examine the level of the seller’s involvement when selling the property. Did the taxpayer spend a significant amount of time finding buyers and negotiating property sales?
- Evaluate the extent and substantiality of the sale transaction. Were there any red flags indicating that
- the sale may not be at arm’s length or
- the price may not be at market value
It is important to understand how these five factors were used in the aforementioned court decisions based on the given facts. In another case Cordell D. Pool, T.C. Memo 2014-3, the Court considered these five factors and ruled against the taxpayer. The case involved a limited liability company, Concinnity LLC (“Concinnity”), organized by three members, who purchased 300 acres of undeveloped land divided into four sections. Three of the sections were part of an exclusive rights agreement with a development company and eventually sold to the development company. On Concinnity’s 2005 return, the gain from this sale was reported as a long-term capital gain. The IRS audited the partnership and disallowed capital gain treatment concluding that Concinnity was a dealer in real estate.
The Tax Court examined the five factors before ruling in favor of the IRS. First, the land was purchased by Concinnity to divide and sell to customers. Second, the frequency of the sales indicated that real property sales were ordinary in the course of business. This determination was based on the sales of the different sections of property. Third, Concinnity took more of a developer’s role than an investor’s role when the company improved the land with water and wastewater systems. In addition, Concinnity found additional investors and brokered the land sale deals. Fourth, there was little proof to conclude that Concinnity did not actively seek out buyers for the individual lots included within the section not sold to the development company. Fifth, the sale to the development company was found to be well above market value and not at arm’s-length, which seemed to imply that a tax avoidance scheme was present. As a result of these findings, Concinnity’s partners were denied capital gain treatment on the sale of the property.
In a court decision, Fredric Allen, 113 AFTR 2d 2014-2262, the California District Court determined that three of the five factors in the case proved the property sale in question was more similar to a transaction in the ordinary course of business, rather than the sale of a capital asset. In the late 1980s, Frederic and Phyllis Allen purchased several acres of land to develop and sell in East Palo Alto, California. After attempting to develop the property themselves, which included hiring engineers for planning purposes, the Allen’s changed their focus and instead tried to find investors to develop and sell the property. In 1999, the property was sold to a real estate development corporation under an installment sale arrangement. On their 2004 Form 1040, the Allen’s reported the final installment payment of $63,662 as long-term capital gains.
The IRS denied the long-term capital gain treatment arguing the property was more similar to inventory for the Allens instead of investment property. The California District Court sided with the IRS based on factors one, four, and five noted above, which strongly indicated that the property was inventory to the taxpayers instead of investment property. The Allens purchased the property with the intent to develop and market the property (Factor 1), and Mr. Allen actively tried to sell the property (Factor 4). In addition, the IRS claimed the transaction was substantial (Factor 5) because the sale priced exceeded $1 million. These factors resulted in the sale requiring ordinary income tax rate treatment.
Both of these cases show the important factors in determining dealer or investor status with respect to land sales. The classification of gain as ordinary or capital is established for each property based on whether the property is held as a capital asset or held for sale in the ordinary course of business. Taxpayers can take the following steps to avoid dealer status:
- Segregate Property in the Books and Records. The segregation of books supports a taxpayer’s intent for holding a piece of property, while also increasing the chances of capital gain treatment when the investment property is sold.
- Report Items as Investment Expense. Deductions related to a piece of property such as interest expense, should be reported as investment expenses. Classifying these expenses as business expenses provides an indication that the property was held for sale in the ordinary course of business.
- Stating Investment Purpose in Governing Documents. If an investor is a partnership, LLC, or corporation, the investor should state in their governing documents that the entity’s sole purpose is investment activities. The intent of investment should also be documented in the meeting minutes.
- Using Separate Entities. One of the factors that determine a seller’s intent is the frequency of sales (Factor 2). To avoid dealer status, it may be advantageous to hold investment property in a separate legal entity with a different ownership structure.
- Insubstantial Nature of the Real Estate Activity. Taxpayers who are able to show that the time spent in investment activities is insignificant when compared to the time spent in their everyday occupation may be able to achieve investor status.
As the gap between long-term capital tax rates and the highest ordinary tax rate continues to grow, the services CPAs can provide become more important to clients. While it may be beneficial to achieve dealer status if a taxpayer has net operating losses, it is often more beneficial for taxpayers not in the real estate business to attain investor status and the preferential tax rates associated with such status. By properly structuring real estate transactions and appropriately setting up records and books, taxpayers have the opportunity to establish dealer or investor status to achieve the desired tax treatment.
Nick Finkenauer, CPA | Director