When is a taxpayer a real estate dealer?

Real Estate Issues, Apr 1996 by Hardin, J Russell, Stocks, Morris H

With the anticipated reduction in the capital gains tax making headway in Congress, the correct classification of real estate transactions once again is being regarded with renewed interest and importance. When the Internal Revenue Service determines that a taxpayer is a real estate dealer and not an investor, the income generated from the taxpayer's real estate transactions is considered as ordinary income rather than capital gain income. This tax issue has been litigated numerous times throughout recent tax history. Chief Judge Brown previously stated that the problem of real estate capital gains vs. ordinary income is "old, familiar, recurring, vexing and ofttimes elusive."

The issue remains complicated since neither the Internal Revenue Code nor the Treasury regulations include an authoritative list of criteria to differentiate the real estate dealer from an investor. Consequently the various courts have had to generate their own list of identifying factors to make a proper determination based on the facts presented. Since numerous cases on the same tax issue have produced inconsistent decisions, this suggests that a specific factor or combination of factors does not always control such decisions. In United States v. Winthrop, the judge said that the factors identified in the law do not separate "sellers garlanded with capital gains from those beflowered in the garden of ordinary income."2

Without the existence of an authoritative list of differentiating factors, the various court opinions must be looked at for critical criteria. This article presents a list of those factors used by the courts to distinguish a real estate dealer from an investor The information it provides should prove useful in tax planning for real estate transactions.

Legislative History Of Capital Gains Taxation

When the language of a federal statute is not clear and the intent of Congress needs to be determined, Congress plays a decisive role in interpreting tax laws.3 The taxation of profits on the sale of real property and other capital assets in the year of realization originated with the Revenue Act of 1864. However, the capital gains provision was first introduced with the 1921 Revenue Act, and it has remained in the Internal Revenue Code although modified many times. The purpose of the capital gains provision was to save the taxpayer/investor from excessive taxes on profits derived from the sale of capital assets where the profit was incremented over a period of time. The first capital gains provision provided for reduced taxes of assets held more than two years. Under prior law, capital gains were taxed as ordinary income.4

The 1939 Code, as amended by the Revenue Act of 1939, continued to provide for preferential tax treatment of capital gains. However, a significant provision of the 1939 Act specified that stock in trade or inventory, property held primarily for sale to customers in the ordinary course of a trade, or business and depreciable property used in a trade or business are not considered as capital assets for purposes of taxation. The 1939 Act also set the holding period for long-term capital gains at 18 months.5

There were adjustments to the capital gains tax provisions between 1939 and 1976, but the basic law remained the same throughout that period. The Tax Reform Act of 1976 established the capital gains taxation rules that remained in effect until the repeal of preferential treatment by the Tax Reform Act of 1986. The 1976 Act set a $3,000 limit on deduction of capital losses against ordinary income. The act also set the holding period for long-term capital gain treatment at 12 months and established the 60 percent deduction for long-term capital gains of non-corporate taxpayers. The 1986 Act effectively repealed preferential treatment of long-term capital gains except for setting the maximum tax rate at 28 percent for non-corporate taxpayers. The original intent of the capital gain holding period provisions was to encourage taxpayers to invest in long-term investments.6

Current Capital Gains Tax Law

Sections 1201-1288 of the 1986 Internal Revenue Code deal with property transactions and capital gains and losses. The code sections 1221, 1222, 1223, and 1237 are mentioned most often in court decisions relative to transactions involving real estate and the capital gain/ordinary income question.

Section 1221 defines a capital asset as property held by the taxpayer, but it differentiates capital assets from depreciable property or real property used in trade or business and from stock in trade or inventory. Section 1222 essentially defines longterm vs. short-term and other related capital gains terms. A long-term capital gain results from the sale or exchange of property held for more than one year. Section 1223 further describes the holding period for capital assets. It also includes a discussion of the holding period for special situations such as involuntary conversions and sale of a personal residence.

Section 1237 deals specifically with subdivided real property The topic of subdivided real estate has been the basis for many court cases. Section 1237 can be very important, because it provides an exemption from ordinary income taxation for certain subdivided real estate. Section 1237(a) states that just because a taxpayer, other than a corporation, subdivides real estate, the resulting sales do not automatically generate ordinary income. The rules for this exception are found in Section 1237(a) paragraphs 1, 2, and 3. Paragraph (1) of subsection (a) states that no part of the property may have been previously held primarily for sale to customers in the ordinary course of business. Paragraph (1) goes on to say that the taxpayer must not have held any other realty for sale to customers in the ordinary course of business at any time during the year of sale. In addition, paragraph (2) states that the taxpayer must not have made substantial improvements to the property so that the value of the property was substantially enhanced. Paragraph (2) also says that improvements made by a family member or other related party, by a lessee, or by a governmental entity shall be treated as if they had been made by the taxpayer. Paragraph (3) concludes subsection (a) by stating that the property must have been held by the taxpayer for at least five years unless acquired by inheritance or devise.