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Archive for June 21st, 2011

A taxpayer purchases multiple pieces of raw land. On some of the parcels, he builds homes which he immediately sells in order to capture the short-term appreciation. On the other parcels, the  taxpayer builds homes which he rents out for several years, hoping to benefit from long-term appreciation.

The taxpayer sells one of the properties. Is the taxpayer an investor or dealer with regards to the sold property? Is the resulting gain capital or ordinary? Or does it depend on which property is sold?  

The Tax Court addressed just this issue  today in Gardner, v Commissioner[i]; holding that a taxpayer  was a dealer with respect to his single-family spec homes, but an investor with respect to his multifamily rentals.

Facts: Over the past 26 years, Gardner had purchased and sold 16 parcels of real property. Often, he would buy raw land, build a single-family residence, and immediately sell the improved property. Gardner also bought raw land and constructed or improved multifamily housing. He did not immediately sell his multifamily housing properties, but rather held them for rental income.

In 2004, Gardner purchased property that had been approved for subdivision into five lots. A few months later, he sold three of the lots, generating gain of $373,841. Gardner reported the gain as short-term capital gain on his 2004 tax return.

Law: The Code does not provide a mathematical or otherwise quantifiable test[ii] to determine whether real property will be treated as inventory or a capital asset in the hands of the holder. As a result, whether an owner of real property is a dealer or investor is a heavily litigated area of the law. Throughout the years,  a series of cases have resulted in the formation of eight factors commonly used to determine a taxpayer’s intent in holding real property (commonly called the Winthrop[iii]  factors):

1. the purpose for which the property was acquired;

2. the purpose for which it was held;

3. improvements and their extent, made to the property by the taxpayer;

4. frequency, number and continuity of sales;

5. the extent and substantiality of the transactions;

6. the nature and extent of the taxpayer’s business;

7. the extent of advertising to promote sales; and

8. listing of the property for sale directly or through brokers.

It is important to note, however, that if the Winthrop factors determine that a taxpayer is a dealer in real estate, that does not preclude the taxpayer from holding other propery with an investment intent. In fact, the Court of Appeals has approved just that scenario.[iv]

Taxpayer Argument: Gardner contended that he purchased the subdivided land in 2004 with the intent of building duplex units,  but financial pressures forced him to sell.  Gardner then conceded that he was a dealer with regards to all of his spec homes, but an investor with regards to his multifamily rental properties, including the raw land purchased in 2004. To support this contention, Gardner cited the fact that he held all of his multifamily rental properties for a minimum of four years, with two held in excess of 20 years.  

IRS Argument: The IRS maintained that the taxpayer’s 20-year history of buying real properties, improving them, and selling them made him a dealer, rather than an investor, under the Winthrop factors.  As a result, Gardner’s $373,841 of gain in 2004 was properly characterized as ordinary income.

 Tax Court: The Tax Court sided with Gardner.  In holding that the raw land Gardner sold in 2004 was investment property producing capital gain, the court took a two-step approach:

1. First, the court accepted Gardner’s testimony that he purchased the raw land with the intent of building multifamily rental duplexes, making the raw land part of his multifamily rental portfolio rather than his spec home portfolio.

2. The court then bifurcated Gardner’s real estate activities into two groups: his spec homes and his multifamily rental properties. The court then concluded, based solely on Gardner’s testimony and the holding periods of the properties, that the multifamily rentals were investment properties.

In reaching its decision, the court stated:

Petitioner also convinced us that he purchased or constructed multifamily rental units not for immediate sale to customers but, rather, as an investment, for rental income and, we assume, appreciation. Certainly, he did sell two of the multifamily rental units, but only after holding them for 4 or 5 years. He has owned two other of those units for over 20 years and the fifth for 4 years. …we are persuaded that the three lots were intended for petitioner’s multifamily rental activity and not his build-and-sell activity.

In this author’s opinion, this was a rather surprising decision by the Tax Court. While I don’t disagree that a taxpayer can hold one piece of property as a dealer and another as an investor, typically the taxpayer is required to prove the investment intent. 

In Gardner, however, the taxpayer was able to convince the court that he was an investor with regards to the sold property with surprising ease. The court readily accepted Gardner’s testimony that he purchased the land with the intent to build rental duplexes, without requiring any additional evidence such as architectural plans or zoning applications. In addition, the court did not insist that Garden provide evidence as to what “financial pressures” forced him to abandon his intent to develop the land and sell the property just months after its acquisition. 

Assuming the land sold in 2004 were intended to join Gardner’s portfolio of multifamily rental properties, this would bring Gardner total number of multifamily rental purchases to six. Three of those properties were subsequently sold, with holding periods ranging from eight months to five years. I find it difficult to see how this limited a purchase history — with 50% of the properties sold in a relatively short period of time — provides such strong evidence of Gardener’s investment intent that the court was content to simply rely on his testimony, rather than performing a formal analysis. 

On a different day in a different court, I could easily envision the same set of facts as seen in Gardner yielding a vastly different result.


[i] T.C. Memo 2011-137

[ii] Aside from Section 1237, which is of limited use

[iii] 24 AFTR 2d 69-5760

[iv][iv] 315 F.2d 101 (6th Cir. 1963)

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