Dealer vs. Investor Real Estate Sales By Scott E. West, EA
Originally published in California Enrolled Agent, Sept/Oct Edition
In this article, we will explore the differences between what constitutes real estate sold as investment property vs. real estate sold in the ordinary course of business. The former receives capital gain treatment. The latter is taxed as ordinary income, possibly subject to self-employment tax. In the wonderful world of tax law, some laws are fairly clear and simple. This is not one of them. This article examines the intricacies of a dealer vs. an investor – a determination that is purely factual and one that can only be made after an examination of all the facts and circumstances.
Even though the Internal Revenue Code section dealing with this area of tax law was written in 1954, there are still various questions that have not been definitively answered in this complex area of law regarding exactly how to define what constitutes a sale of investment real estate vs. a sale of property of a real estate dealer. In the appeal of the Byram case,1 Circuit Judge Gee makes the following quotation from an old tax textbook regarding real estate sales. “If a client asks you in any but an extreme case whether, in your opinion, his sale will result in capital gain, your answer should probably be, ‘I don’t know, and no one else in town can tell you.’“ So, when your client walks into your office with a real estate sales question what advice will you give?
Any discussion of tax law should start with the Internal Revenue Code. The part of the code we will be reviewing for this subject is found in IRC §1221(a)(1):
§1221. Capital asset defined
(a) In general
For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include—
(1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;
Now that doesn’t sound too complicated, does it? But here we are, 69 years after this code section was written, and courts still disagree on how to interpret it. Let’s review some of the important things that the courts have said. The first case to mention is the Suburban case.2 It states that there are three principal inquiries demanded by the statute:[box] 1. Was taxpayer engaged in a trade or business, and, if so, what business?
2. Was taxpayer holding the property primarily for sale in that business?
3. Were the sales contemplated by taxpayer “ordinary” in the course of that business?[/box] To answer the first question we need to determine if the real estate activity is sufficient to constitute a business. In the Reese case,3 it states “The term ‘trade or business’ contemplates a regular and continuous course of conduct rather than sporadic or isolated transactions. The amount of time as well as money devoted to the project is also important in determining whether the undertaking constitutes a trade or business.”
When I evaluate this question, I review the factors that determine whether an activity is a hobby or a business. If the real estate sales activity is not sufficient to be deemed a business, then the gain or loss should be capital in nature. If the sale is part of a trade or business of selling real estate, then we move on to question number two.
Was the taxpayer holding the property primarily for sale in that business? This question may not sound that complicated on the surface, but it has been the subject of a great deal of litigation, and various judges have made contradictory conclusions in this area. In the Malat vs. Riddell case,4 they disputed how to interpret the phrase ”primarily for sale” all the way to the Supreme Court. The Supreme Court interpreted “primarily” in the phrase “primarily for sale” to mean “of first importance” or “principally.” Thus, if a taxpayer’s purpose in holding property is multiple, the sale purpose must be more than substantial, it must be the primary purpose. A “yes” answer to this question leads us to question number three.
Were the sales contemplated by the taxpayer ”ordinary”in the course of that business? Perhaps at first glance this would seem to be a redundant question. After all, if a person is in the business of selling real estate, then selling a property would seem to be within the ordinary course of that business. However, various courts have made it clear that it is possible for a business that regularly sells real estate to also hold different real estate for investment purposes. In order for an entity that regularly sells real estate to receive capital gain treatment on the sale of a particular property, it would have to show how this property is distinguishable from those sold in the ordinary course of business.
The Gardner case5 is one example of a real estate dealer who successfully argued that certain lots should be treated as investment property. Tollis6 and Suburban are a couple of cases where dealers could not convince the court that their particular sales should receive capital gains treatment. These are a few of many cases you can review and compare the facts with your particular situation.
We know from studying tax law that both the courts and the IRS often use factors to analyze complex areas of law. For example, there are factors to determine employee vs. contractor status. We also have factors to determine whether an activity is a business or a hobby. The courts have also used factors to analyze this question of dealer vs. investor. However, the courts have not agreed on exactly what those factors are, nor even the number of factors to be used. Five factors are used in the Lowery case.7 In the Winthrop case there are seven,8 and eight factors are used in Mathews.9
For this article, we will review the seven factors found in United States vs. Winthrop:
- The nature and purpose of the acquisition of the property and the duration of the ownership.
Although the nature and purpose of the acquisition is important, various courts have determined that the purpose for which a property is held can change, and some have said that the purpose at the time of sale is what should be considered. However, in the appeal of the Suburban case we read “At the very moment of sale, the property is certainly being held ‘for sale’. The appropriate question certainly must be the taxpayer’s holding purpose at some point before he decided to make the sale in dispute.”Regarding the duration of ownership, in the Malat vs. Riddell case, the Supreme Court explained that the purpose for Section 1221(1) of the Internal Revenue Code was to differentiate between profits and losses “arising from the everyday operation of a business” and “the realization of appreciation in value over a substantial period of time.” Unfortunately, there is no concise definition of “substantial period of time.”
- The extent and nature of the taxpayer’s efforts to sell the property.
A real estate dealer could be expected to have a business plan to sell his properties at a profit. This could include sales staff or regular contracts with brokers or other affiliated professionals to assist in the property sales. The lack of these things could indicate investor status.
- The number, extent, continuity and substantiality of the sales.
How many sales does it take to constitute a business? Unfortunately, the answer is one or more. In Reese vs. Commissioner, the Fifth Circuit Court of Appeals held that “a single transaction ordinarily will not constitute a trade or business when the taxpayer enters into the transaction with no expectation of continuing in the field of endeavor.” However, in Boyer vs. Commissioner,10 they had the land rezoned, surveyed, platted, and installed sewers and streets. Because of the extensive development activity attributed to the Boyers, they were deemed dealers even though it was their first such transaction.
- The extent of subdividing, developing, and advertising to increase sales.
Taxpayers can be involved in development activities to some extent without being considered dealers. But, the greater the time and effort expended by the taxpayers on improvements to the property, the more likely they are to be treated as dealers in real estate. A substantial and continuing marketing plan is something you would expect from a dealer. Unsolicited sales or a sporadic advertising plan would be expected from someone who was merely an investor.
- The use of a business office for the sale of the property.
Typically, a real estate dealer will have a sales office. However, the lack of a sales office does not automatically mean the taxpayer is an investor. In the Winthrop case, the court originally ruled that the sales should be treated as capital gains. But on appeal the lower court’s ruling was reversed. They did not have a sales office or any organized marketing plan, but they sold more than 450 lots over an 18 year period. The gain on the lots represented more than half of Winthrop’s income for the period and he spent the majority of his working time on the project.
- The character and degree of supervision or control exercised by the taxpayer over any representative selling the property.
A dealer would tend to exercise more control and supervision of those involved in selling the properties than an investor would.
- The time and effort the taxpayer habitually devoted to the sales.
A real estate dealer would dedicate time to sales on a continuous and substantial basis. This is not necessary for a real estate investor.
This article has explored various questions related to the sales of real estate. It doesn’t give all the answers, because, frankly many questions in this area do not have definitive answers yet. When that person comes into your office with a question regarding real estate sales, this article can be used as a reference to study the various issues involved. On the other hand, you could just send them to someone in the next town.
Scott E. West, EA started preparing tax returns in 1982, and passed the Enrolled Agent exam in 1989. He is an NTPI Fellow. His biggest areas of practice are real estate transactions and self-employed taxpayers. His business, L & S Tax Services, is located in Sacramento, California.
1 Byram vs. U.S., 52 AFTR 2d 83-5142 (705 F.2d 1418).
2 Suburban Realty Co. vs. U.S., 45 AFTR 2d 80-1263 (615 F.2d 171) 04/07/1980.
3 Reese vs. Commissioner, 615 F.2d 226, 45 AFTR 2d 80-1248 (CA 5, 1980).
4 Malat vs. Riddell [65-2 USTC ¶9452].
5 Mark S. and Cheryl R. Gardner vs. Commissioner, U.S. Tax Court, T.C. Memo. 2011-137, 101 T.C.M. 1658 (Jun. 20, 2011).
6 Zane R. Tollis, et al., T.C. Memo. 1993-63.
7 Tax Court Memoranda (Archive), Sylvester A. Lowery vs. Commissioner, U.S. Tax Court, CCH Dec. 26,645(M), T.C. Memo. 26,645(M), 23 T.C.M.152, T.C. Memo. 1964-30, (Feb. 10, 1964).
8 UNITED STATES of America, Appellant, vs. Ada Belle WINTHROP, Individually and as Executrix under the will of Guy L. Winthrop, Deceased, Appellee. 417 F.2d 905.
9 United States Tax Cases (1913-1999), [63-1 USTC ¶9360], J. Stewart Mathews and Viola I. Mathews, Petitioners vs. Commissioner of Internal Revenue, Respondent , (Mar. 22, 1963), U.S. Court of Appeals, Sixth Circuit, (Mar. 22, 1963).
10 Boyer vs. Commissioner [58 T.C. 316, 318-325 (1972)].