If the IRS classifies a sale of real property as a “dealer” sale — meaning the property was held for sale to customers in the ordinary course of a trade or business — the tax ramifications can be dramatic. How, you might ask? The gain on the sale will be treated as ordinary income, rather than capital gain. The U.S. Tax Court recently shed some light on how it determines whether property is held primarily for sale to customers in the ordinary course of business.
IRS challenges characterization of gain
A California couple conducted real estate business through several entities. These included Fargo Industries Corporation (FIC), a C corporation wholly owned by the husband, and Girard Development (Girard), a partnership in which the couple were the majority partners. In 1988, FIC acquired a leasehold in some property, with plans to develop a 72-unit apartment complex and retail space. It collected rent from some tenants in a building on the property, and some of the couple’s rental companies also used the building for their operations.
In 1991, FIC transferred the leasehold to Girard, which entered various agreements for the development and management of the property. Several hurdles arose, however, including a major decline in the local real estate market. Development was suspended, but Girard continued to seek financing to develop the property.
Girard bought the property in 1997, and, through 2001, the property was developed for residential use. The extent of physical improvements was limited to minor repairs. In 2001, Girard received an unsolicited offer to purchase the property for $14.5 million, plus a share of the home sales profits. Under the plan, the husband would develop the property and Girard would share in the resulting profits from home sales.
The sale was completed in 2002, and Girard reported a capital gain of $628,222 on it. The IRS audited the tax return and found that the partnership had realized ordinary income in the amount of almost $7.5 million. The couple and Girard ended up in Tax Court.
Court rules for the IRS
Girard conceded that the property was originally acquired for development but contended that it held the property primarily to allow the market to recover from the recession. The property, it was argued, should therefore be viewed as an investment.
The Tax Court had previously identified nine factors for evaluating whether property was held primarily for sale to customers in the ordinary course of business. Although four of the factors in this case favored the taxpayers, the court focused largely on a different factor — the purpose for which the property was held at the time of sale.
It noted that Girard had purchased the property and held it primarily to develop and sell later to customers. This intent, the court said, was never abandoned and remained the primary motive for holding the property. In addition, Girard incurred significant development expenses and stood to share in the profits from development of the property after the sale. The court ruled for the IRS.
Proceed with caution
This case is a valuable reminder that the collection of rent over a lengthy holding period that ends in a single sale isn’t enough to guarantee that a property sale will enjoy capital gains treatment. The seller’s intent at the time of the sale could overshadow such factors weighing in its favor.