When Is Real Estate a Capital Asset, and When Is It Not?

By James A. Fellows and Michael A. Yuhas

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There is much talk of a national real estate “bubble” in the same fashion as there was regarding the famous stock market bubble at the end of the 20th century. Will the real estate bubble burst like the stock market one did? Will real estate prices stabilize, or go down, ending the usual double-digit annual percentage increases? There is already evidence of this happening, even in “hot” real estate markets such as Florida.

But these things ebb and flow, and nobody can reliably predict the future. Rather, the purpose here is to analyze tax consequences of buying and selling real estate—in particular, the result when real estate assets are sold at a gain and when they are sold at a loss. Much of the confusion is due to a lack of understanding of when real estate is a capital asset and when it is not. A recent court decision reminds taxpayers that the issue is anything but settled.

What Is a Capital Asset, Anyway?

Suppose that Terry Taxpayer, CPA, has a side business acquiring older residential homes for rehabbing. Terry fixes up these homes and resells (flips) them to new homebuyers. Terry operates this enterprise through a single-member limited liability company (SLLC). An SLLC is a “disregarded entity” for tax purposes. Although it is a separate legal entity providing protection for Terry’s personal assets, it is ignored for tax purposes, so any gain or loss on the sale of flipped homes is reported directly in Terry’s tax return.

The good, the bad, and the confusing. Assume that Terry makes a healthy profit on each of the flipped homes. How should Terry treat the gain on the sale? Is this a capital gain, taxed at a maximum rate of 15% if Terry has owned the house more than one year? Or is this ordinary income, taxed at Terry’s ordinary income tax rate of 35%? If a flipped home is properly classified as Terry’s inventory, then Terry is considered a dealer in real estate, rather than an investor. Any gain is ordinary income, taxed at 35%, not 15%.

In addition, Terry will owe self-employment tax on the income. We can assume that Terry has already reached the old age, survivor, and disability income (OASDI) limit with his salary, but he is still liable for the 2.9% Medicare tax on the income. This raises his effective tax rate on the income to 38% if he is a dealer. Classification as investor or dealer is obviously important to Terry, given this 23% differential. For every $10,000 of profit on a sale, there is a tax savings of $2,300 if the property is an investment (i.e., a long-term capital asset instead of inventory to be taxed as ordinary business income).

Suppose that Terry needs only five or six months to rehabilitate the house. Then, even if he is considered an investor, the gain would be classified as short-term capital gain and does not receive the lower 15% rate. Instead it is taxed at Terry’s 35% rate. IRC section 1222 states that only capital assets held more than one year qualify for the lower 15% rate on long-term capital gains. The self-employment tax issue does not exist in this case, but there still is a differential of 20% if the gain is short-term as opposed to long-term.

Now assume another scenario, where the real estate market has taken a downturn and home prices have declined. After investing money in rehabilitating the homes, Terry finds that he can sell the homes only at a loss. For example, one home was purchased for $50,000 and Terry put in another $70,000 of rehab work. His tax basis in the home is now $120,000, but he finds that he can sell it only for $100,000. Because he borrowed heavily, he needs to sell it for the cash. If he sells the home at this $20,000 loss, is the loss a capital loss, or ordinary? Again, the answer depends on whether the home is a capital asset or inventory.

Note that in this case, where there is a loss, Terry doesn’t want the home classified as a capital asset. He wants it classified as inventory. If Terry is flipping these homes at a loss and the losses are capital losses, then he is allowed to deduct the losses only against capital gains, and there may not be any gains in a down market. After the netting process, any net capital loss is limited under IRC section 1211(b) to a $3,000 deduction per year. IRC section 1212 allows for an unlimited carryforward for unused losses, but at $3,000 per year, fully deducting all of them can take a long time. On the other hand, if the property is properly classified as inventory, then Terry is considered a dealer, and any loss is fully deductible on his return. There is no $3,000 limitation because it is now a business loss rather than an investment (capital) loss.

Of course, Terry cannot have it both ways. He cannot argue that his flipped homes are capital assets when he is able to sell them for a gain and inventory when he sells them for a loss. What are they, then: inventory or capital assets?

The answer depends on who you ask. One “urban tax legend” that won’t go away is the belief that all real estate is a capital asset. This is not true. Real estate can indeed be a capital asset, but often it is classified as inventory, which by definition is not a capital asset. Any gain on inventory sales is business income, taxed at ordinary tax rates, not capital gain tax rates. And any loss is fully deductible, not limited as capital losses are. The reason real estate can be a capital asset or inventory, depending on the case at hand, starts with the definition of a capital asset in the IRC.

The statutory rule. IRC section 1221(a)(1) defines a capital asset in a negative fashion. It states that all assets are capital assets except those listed in the statute itself. For our purposes, one asset listed as not a capital asset is “property held by the taxpayer primarily for sale to customers in the ordinary course of business.” Admittedly some of these terms are ambiguous; for example, “primarily for sale” and “the ordinary course of business.” These are subject to interpretation by the IRS and the courts. In the end, whether the taxpayer is an investor or a dealer is a question of the facts in each individual case. There simply is no bright line that, if crossed, moves the taxpayer from one side to the other.

According to another urban tax legend, real estate held for more than one year automatically becomes a capital asset. This belief stems from the aforementioned IRC section 1222, which states that capital assets held more than one year are defined as long-term capital assets, and thus eligible for the preferential 15% tax rate. If a capital asset is held for one year or less, it is a short-term capital asset and not eligible for the 15% lower rate.

But this one-year rule applies only when taxpayers have first established that they have a capital asset. If the asset is instead classified as inventory, there is no bright-line one-year rule that transforms the gain to a long-term capital gain, or the loss to a capital loss. Regardless of how long the real estate is held in this situation, if it is inventory, then gain and loss are ordinary, not capital. If Terry Taxpayer in our example takes more than one year to rehabilitate a house he bought, the 15% tax on long-term capital gains occurs only if the house is classified as a capital asset. If he is a dealer, the house is inventory and is taxed as ordinary business income. The one-year rule is simply irrelevant here.

If a taxpayer has a primary occupation other than real estate, this does not automatically exclude the taxpayer from being labeled a dealer [Gilford v. Comm’r, 201 F.2d 735 (Second Cir., 1953)]. Perhaps this is another tax urban legend that needs correcting. For Terry Taxpayer, the fact that he is a full-time practicing CPA does not automatically entitle him to exemption from dealer status. A business can be operated on weekends, after hours, and through delegation to others (e.g., subcontractors).

The Best and the Worst of All Possible Worlds

Taxpayers cannot simply designate themselves as investors or dealers. The popular thing to wish for is probably investor status, in order to get long-term capital gain treatment on asset appreciation in a rising market. But those buying older homes for flipping in a relatively short timeframe, say several months, might actually prefer to be a dealer. Consider the following scenario.

Donna Developer is a full-time tax attorney. As a side business, she also uses an SLLC to buy older homes, then rehabilitate them for eventual sale to new buyers. The entire process from acquisition to sale usually takes six to nine months. Rarely does it exceed one year. Donna is in the 35% tax bracket and has no other capital gains and losses for the year. If Donna is considered an investor and she sells the homes at a profit, they are short-term capital gains, taxed at 35%. If she sold five homes during the year for gains totaling $300,000, Donna has a tax liability of $105,000.

But what if Donna sells the homes at a loss in a down market? Assume that her net total losses are $120,000. These are short-term capital losses, and only $3,000 is deductible in the current year. The remaining $117,000 can be carried forward into future years, but deducting all of her losses at $3,000 each year will take 39 more years, assuming no future capital gains.

Donna might actually be better off being classified as a dealer. If she has $300,000 of gains from the sale of the homes, it is ordinary income from the sale of inventory, taxed at 35%. Because she is a dealer, she will owe self-employment tax on the earnings, raising her effective tax rate to almost 38%. Her salary as a tax attorney is high enough so that she does not owe any of the OASDI tax at 12.4%, but she is still liable for Medicare tax of $8,700 ($300,000 x 0.029). This means her total tax is $113,700 ($105,000 + $8,700), more than the $105,000 if the profits were classified as capital gains.

On the other hand, if Donna has $120,000 of losses from the sale, these are ordinary business losses. As such, they are immediately deductible on her tax return, to offset some of her lucrative salary as a tax attorney. She doesn’t have to spread her deductions over a 40-year period.

If dealer status is the end result, then taxpayers do not have the option of reporting any profits on the installment method, even if they take back an installment note as part of the sale. IRC section 453(b) disallows installment reporting by dealers, unless the gain is attributable to unimproved lots, which is not the case for taxpayers who are rehabilitating homes. Installment reporting is available, however, for real estate investors who sell the homes for capital gain, even short-term capital gain. This allows deferment of the tax until collections on the note are made.

The upshot is that it is not always beneficial to be classified as an investor, although for most taxpayers it will probably work out that way. Dealer status may be preferable in other cases (see the discussion below). What is most favorable for tax purposes will depend on the circumstances. Regardless of their preferences, taxpayers cannot simply designate what they are. It is a matter of facts and circumstances in each individual case. Tax advisors should be familiar with court cases that might fit a taxpayer’s situation, and even then it is going to be a judgment call. The tax consequences follow from the final result, which is often not finally determined until litigation ensues.

Judicial Doctrine

The courts have much to say about investor versus dealer status, but finding common ground among the decisions is difficult. Taxpayers looking for a cookie-cutter method to ensure investor (or dealer) status will be disappointed, but they will find some amount of guidance. The courts have mainly focused on the definition of inventory found in IRC section 1221(a)(1). As discussed above, inventory is defined as “property held by the taxpayer primarily for sale to customers in the ordinary course of business.”

The U.S. Supreme Court [W. Malat v. Riddell, 393 U.S. 569 (1966)] has interpreted the word “primarily” in IRC section 1221(a)(1) to mean “principally” or “of first importance.” By this the Supreme Court meant that “primarily” does not include sales of property that are the culmination of appreciation of property over a substantial period of time, as opposed to ordinary business profits resulting from the operation of a business. But this does not address the meaning of “principally” and “of first importance.”

Three questions, seven factors. Following Malat, courts have tried to put some meaning behind the nuances of the Supreme Court ruling. The most famous and most cited decision is Suburban Realty Co. v. U.S. [615 F.2d 171, CA-5 (1980)]. In this case, the Fifth Circuit Court of Appeals posed three questions that should be asked to determine investor versus dealer status:

• Was the taxpayer engaged in a trade or business, and if so, what business?
• Was the taxpayer holding the property primarily for sale in that business?
• Were the sales contemplated by the taxpayer “ordinary” in the course of that business?

The Suburban court then enumerated seven factors that should be considered in answering these questions. These factors are now used to provide guidance to taxpayers and the IRS when dealer or investor status is being decided:

• The continuity of sales over a continuous period of time;
• The number and frequency of sales;
• The extent of sales activities such as developing or improving the property;
• The volume of sales in relation to the taxpayer’s other sources of income;
• The desire to liquidate land acquired unexpectantly, such as by inheritance;
• Reluctance on the part of the taxpayer to sell the property; and
• The amount of gain from the sale.

Although no one factor is supposed to predominate, practical considerations seem to have taxpayers, the IRS, and the courts emphasizing the first two factors: continuity of sales over a continuous period of time, and the number and frequency of sales [see Bramblett v. Commissioner, 960 F.2d 526, CA-5 (1996)]. Of course, what tips the scales one way or the other depends on the facts of each case.

Bio-Med decision. In a recent decision (Diane Reed, Trustee v. IRS, DC-North Texas, May 2, 2006), the U.S. District Court in Dallas held that the taxpayer was not a dealer and therefore could not deduct ordinary losses from the sale of real estate. The case involved a Chapter 7 bankruptcy liquidation of Bio-Med Services Corporation, whose principal business was the transportation of medical specimens between doctors’ offices and laboratories. During the bankruptcy proceedings, the bankruptcy trustee filed suit on behalf of the bankruptcy estate against the owners of Bio-Med, alleging misappropriation of funds. In settlement of the suit, the owners transferred six tracts of unimproved land to the bankruptcy estate.

The trustee then sold the land for a net loss of $378,000. The court had to determine whether these were capital losses or ordinary losses. There were net operating profits from the Bio-Med business in a prior year, and the trustee wished to carry back the losses as ordinary business losses under the net operating loss rules of IRC section 172. Bio-Med did not have any capital gains in the prior years, so any carryback of capital losses would have generated no tax benefit, because capital loss carrybacks can be used only against prior-year capital gains.

The trustee argued that because Bio-Med was being liquidated, it did not have any other business than the selling of that real estate. The previous business of Bio-Med (transporting medical specimens) no longer existed. In other words, in answering the three questions proffered by the Suburban court, the trustee put forth:

• Yes, we are engaged in a trade or business, and that business is the sale of real estate;
• Yes, we are holding property primarily for sale in that business; and
• Yes, these sales were all contemplated in the ordinary course of the business.

The district court disagreed with this reasoning. In its opinion, the prebankruptcy business of Bio-Med remained its principal business activity. The court stated that the trustee is not authorized to change or alter the primary business of the debtor corporation without the bankruptcy court’s permission (which was not given in this case). The sales of the real estate were therefore merely tangential to the main business activity of Bio-Med. Because Bio-Med was not in the business of selling real estate, the losses from the sale of the real estate were ruled to be capital losses.

Flipper Revisited

The judicial history of investor versus dealer status will leave current real estate investors and their advisors struggling to determine their tax status. The three questions and seven factors from the Suburban decision offer at least some guidance. Tax advisors should probably use the seven factors as a checklist. The crucial determinants seem to be frequency of sales over a continuous period of time, as well as the extent of development activities. Developing property may also be a leading indicator of dealer status.

In a typical real estate flipper case, the taxpayer undertakes substantial improvements to the property in order to sell it at a premium. But if this is done only a few times, the “frequency of sales” effort is missing, so the flipper would probably be considered an investor. Although it is not conclusive, if the flipper has a full-time job in addition to rehabilitating and flipping homes, this goes a long way toward ensuring investor status, but only if sales are infrequent.

Suppose that Terry Taxpayer, the CPA from the earlier example, buys and sells roughly three homes a year. Because this is not Terry’s full-time business and the sales are not frequent, his status is almost surely that of an investor. But just because Terry has a full-time job as a CPA does not insulate him from dealer status. If he rehabilitates six or seven homes a year for several years in a row, then the IRS will surely assert, and probably with success, that Terry has another business other than his job as a CPA.

©2009 The New York State Society of CPAs. Legal Notices