Ref: Internal Revenue Code Sec 1231; TC Memo 2019-95 (Ashkouri v. Commissioner); Long v. Commissioner (772 F.3d670 (2014))
Tax on disposition of real estate can vary widely depending on the intent of the developer/investor and the facts/circumstances behind the project. The two cases, from 2019 and 2014, respectively reflect how the Courts now view such transactions.
The IRS’ default when there is not clear intent through actions and documentation is to treat a disposition as inventory and the taxation as ordinary income.
IRC Section 1231 provides an exception IF the property is used in a trade/business OR held for investment. The most common trade/business real estate is that actively rented to a third party and held for more than one year (in order to qualify for long-term treatment of capital gains).
Investment: An example of investment property would be a run-down vacant building purchased over one year ago, remodeled and sold at a profit.
Inventory: A common example of inventory would be ten acres of land subdivided upon which was built twenty new homes and sold to individual owners.
Long case, cited above: The Court looked not only at the intent of the taxpayer but also at holding period, and evidence supporting both in determining that the income was long-term capital gain.
Ashkouri case, cited above: Although the taxpayer took a position that the income was long-term capital gain, the Tax Court determined that the “… sole purpose and function was to acquire, hold, develop, operate, and sell the condominium complex of which Unit B was a part.” As such, the Court changed the classification to the sale of inventory taxed as ordinary income and not long-term capital gain rate.
As it is possible for one entity to hold property falling into both classifications, inventory and capital/investment, documentation of intent starting at the beginning of each project is substantial evidence of the type of development being undertaken.
