Real Estate Activities Versus Investments: Why it Matters
Justin L. Sylvan
The characterization of a real estate entity’s activities as a business or an investment makes a big difference to the bottom line when it comes to taxation. In Conner v. Commissioner, a developer whose plans were derailed by the Great Recession recently learned this lesson the hard way.
Business or investment
The taxpayer was the sole shareholder of an S corporation that operated as a custom homebuilder. The business did not own the lots where homes were built or maintain an inventory of partially or totally completed homes. He also was the sole member of several limited liability companies (LLCs) through which he acquired large tracts of undeveloped land. The LLCs had no employees or management offices.
The taxpayer had the LLCs’ tracts surveyed and development plans prepared, but the plans were never executed. Shoreline, one of the LLCs, sold all of its property in a single sale at a loss in 2013. At the time of the sale, the land was in a conservation program in which the taxpayer had placed it to reduce property taxes. As part of the requirements for conservation use, he had certified that business would not be conducted on the land.
The taxpayer nonetheless claimed a fully deductible ordinary loss on the sale, contending that Shoreline held the land in the ordinary course of business. The IRS asserted that it was a capital loss and subject to strict limitations because Shoreline had held the land for investment.
Ordinary or capital loss
The tax laws deem property held by a taxpayer primarily for sale to customers in the ordinary course of trade or business to be an ordinary asset. To determine whether a real estate asset is an ordinary or capital asset, the court considers such factors as:
- The number, extent, continuity and substantiality of sales; and
- The extent of subdividing, developing and advertising.
While no specific factor is controlling, the court noted that the frequency and substantiality of sales are particularly relevant because they undermine the contention that property is a capital asset being held for investment rather than sale. Shoreline had only one sale over eight years, and the taxpayer made no effort to sell its property.
The taxpayer did not advertise the property, list it, maintain a sales office or employ a sales force. The land was sold after an unrelated party made an unsolicited offer. Thus, the court found that the isolated nature of the transaction supported capital loss treatment.
In addition, Shoreline held the property from 2007 to 2013 without engaging in development-related activities, despite having earlier secured permits and prepared design plans. Shoreline’s expenses consisted entirely of holding costs, such as mortgage interest and property taxes, and the conservation program prohibited the land’s development. The court ultimately concluded that the evidence indicated the taxpayer had incurred a capital loss.
Business or investment expenses
The IRS also challenged the taxpayer’s characterization of the LLCs’ expenses. Under the tax code, investment expense deductions are subject to limitations that do not apply to business expense deductions. The taxpayer here claimed that the LLCs’ expenses were business expenses. According to the taxpayer, the land the LLCs held was for development that was delayed by the economic downturn.
However, the court found that the taxpayer’s LLCs held land for investment, not as part of an ongoing development business. The taxpayer never subdivided or improved any property. The development of each property stalled in the planning stage, with each property remaining in the same condition as it was on the date of acquisition. “Carrying on a trade or business,” the court cautioned, “requires more than just preliminary planning and permitting.”
Walk the walk
To obtain the more favorable tax treatment generally granted to business activities, be sure to take steps to help distinguish your activities from mere investments. As the court highlighted in this case, cursory planning and permitting are not enough—you must demonstrate more in the way of sales and development.
Sidebar: Taxpayer prevails on charitable contribution of lands
It was not all bad news for the taxpayer in Conner v. Commissioner. The Tax Court rejected the IRS’s challenge to a charitable contribution deduction that the taxpayer had claimed on his S corporation’s sale of undeveloped land in a bargain sale to a church.
The taxpayer had claimed a deduction for the difference between the sale price and the land’s fair market value. The IRS, on the other hand, argued that the S corporation held the land as an asset in the ordinary course of business, so the deduction was limited to the difference between the sale price and the S corporation’s cost basis.
But, the court found that the land was a long-term capital asset held for investment. The S corporation, it observed, had acquired the land in 2005 and did not sell it until 2013. The Tax Court found that the taxpayer held all of its land for investment and did not sell land in the ordinary course of business.
For more information, contact Justin Sylvan at firstname.lastname@example.org or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.