Archive for July 12th, 2012

Remember the good ol’ days when the real estate market was so prosperous, every schlub on the street was buying land, building a spec home and selling for a tidy profit?

Those days are long gone, but pity those who built their spec home right before the crash, who instead of walking away with a pile of money were rewarded for their efforts with a large loss and financial ruin.

To soften the blow, many of these unfortunate investors will argue that they were in the trade or business of constructing spec homes — even when they only had one build on their resume  —  so as to deduct the loss as ordinary on their income tax return.

The IRS, of course, will argue the opposite: that the spec house was not constructed for sale in “the ordinary course of business” and thus was a capital asset, limiting the taxpayer to a capital loss that can only offset capital gains, plus an extra $3,000.

Now understand this: determining whether a piece of developed property is inventory — thus generating an ordinary loss — or an investment — generating capital loss — is not an open and shut analysis. This is, as much as any analysis in the tax law, an inquiry that is dependent on the facts and circumstances of each case.

Throughout the years, the courts have produced an impressive volume of case law on this “dealer versus investor” issue, and as a byproduct, a list of factors have evolved to aid in the analysis. While typically, the argument centers on the other, income, side of the equation —  with taxpayers pleading for capital gain treatment while the IRS pushes for ordinary income — these factors prove equally helpful in determining the character of a loss resulting from an isolated sale of developed real estate.

Consider the case of Darron (not a misspelling) Bennett, a self-described “serial entrepreneur” who decided to try his hand at developing a home in Carlton Banks’ hood — the Bel Air neighborhood of Beverly Hills.

In 1997, an old friend roped Bennett into taking a piece of raw land located in Bel Air off his hands. Bennett called Nevada home at the time, but he would spend 85% of his time at the Bel Air site handling the “design side” of the home construction.

In 1999, Bennett refinanced the property for $2,500,000, and on his loan documentation he indicated that he would occupy the home as his primary residence. One year later, he’d refinance again, this time indicating that he would not occupy the home as his primary residence.

In 2001, Bennett sold the unfinished home for $4,000,000, realizing a loss of $1,300,000 that Bennett deducted as an ordinary loss on his 2001 Form 1040.

The IRS denied the loss, arguing in the alternative that:

1. The house was intended to be Bennett’s primary residence, so any loss on the home was an unallowable personal loss under Section 165(c), or

2. The house was a capital asset — not a business asset — and thus the resulting loss was capital.

The Tax Court made short work of the first argument, holding that there was no evidence that Bennett intended to occupy the home as his primary residence. While he indicated on his loan application that he would do so, the court acknowledged that it is common practice for borrowers to fudge those applications in search of better lending terms, so the court disregarded this minor slip-up on Bennett’s part.

With regards to the second argument, a full-blown analysis was required. The following factors, developed by the Ninth Circuit, were used to determine if the Bel Air home was an investment property or inventory:

  1. The nature of the acquisition of the property,
  2. The frequency and continuity of sales over an extended period,
  3. The nature and the extent of the taxpayer’s business, and
  4. The activity of the seller about the property.

The Tax Court ultimately concluded that the Bel Air home was not built for sale in the ordinary course of business to customers, and thus generated capital, rather than ordinary loss. Relevant points for each factor were as follows:

1. The nature of the acquisition of the property:

The court decided this factor in favor of Bennett, concluding that because the home was not to be used as a primary residence, and because Bennett had enlisted the help of an architect/builder to help develop a saleable property, the Bel Air home was meant to be sold.

 2. The frequency and continuity of sales over an extended period:

While previous courts have held that very few sales can still reach the level of a trade or business, the Tax Court refused to do so in this case, deciding this factor against Bennett. There was no preexisting arrangement at the time Bennett acquired the property to quickly resell it, a fact that distinguished Bennett’s facts from previous taxpayer-friendly decisions.

3. The nature and the extent of the taxpayer’s business:

The fact that Bennett did not previously, or subsequently, engage in real estate development — exacerbated by the fact that he improperly reported the activity from the Bel Air property throughout the years on his tax return — convinced the court to decide against Bennett on this factor.

4. The activity of the seller about the property:

Bennett did himself no favors here. He hired a friend as his realtor. He never tried to advertise the property or prepare for the sale of the property. In fact, Bennett testified that he was “just trying to be rid of the property.” Add these up, and the court was obligated to decide against him here, and ultimately conclude that the property was not held for sale in the ordinary course of business.

What’s the lesson? If you’re one of the unfortunate souls still trying to unload a spec home you built pre-2008 and you’re angling to take an ordinary loss, you need to know the factors, and behave accordingly. Run it like a business, keeping books and records. Try like hell to sell the property through advertising, hiring unrelated brokers, etc… And for god’s sake, don’t admit you were “just trying to get rid of it.”

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Joe Kristan over at Roth & Co. has the full details, but this is certainly a case that warrants attention and may carry some interesting implications. We don’t want to step on Joe’s toes with the write-up, so we’ll just touch on why the decision is important and you can head over to Roth & Co. for the details.

In the early 2000’s, demutualizations were all the rage. In a demutualization, a so called “mutual insurance companies” — called such because policyholders own not only their insurance policy, but also an interest in the company such as the right to vote on corporate decisions or to receive corporate surplus upon liquidation– converts to a stock issuing company prior to going public.

When the mutual insurance company converts, policyholders continue to hold their insurance policies, but are also granted stock in the new corporation to replace their former “ownership” rights.

An issue has always been how the policyholder determines his basis in the corporate stock received. On one side, the IRS has long maintained that the policyholder takes a zero basis in the stock, so that any subsequent sale will generate pure gain.

To the contrary, taxpayers have argued that the “open transaction doctrine” should apply to the demutualization. Become, taxpayer’s argue, the premiums they paid cannot be allocated between their dual interests after the conversion of policyholder and stock holder, all of the taxpayers premiums should be applied against any proceeds subsequently received upon the sale of the stock in determining gain.

The open transaction doctrine for demutualizations was blessed in 2008 by the Court of Claims in D.C. in Fisher , and approved by the Court of Appeals.

On Monday, however, an Arizona District Court challenged the use of the open transaction doctrine in demutualizations, arguing that the policyholder’s premiums could be allocated between the stock received and continuing interest in the insurance policy, giving the policyholder a “basis” in each interest. Only the basis allocated to the stock received could be used against subsequent sales proceeds in computing gain or loss.

The District Court did not determine the proper methodology for allocating basis among the stock and policy; instead, the case will head for trial and a methodology will be established.

Check out Joe’s write-up for the details.

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