Tax Court Tackles “Dealer Versus Investor” Issue; Flood v. Commisioner, Examined
In nearly every Masters in Taxation program across the country, first-semester students are required to take a “Research and Writing class,” in which a humbling process repeats itself over and over: First, the student is assigned a topic and asked to research it thoroughly before handing ina writtenmemo summarizing their findings. At which the professor ritualistically destroys the student’s hard work by going to town with a red pen,with nary a sentence left unscathed.
This, of course, is done by design. The professors intend to show you that the tax world is no-nonsense, and that while you may fancy yourself a skilled writer because your buddies enjoyed the hilarious narrative you included with your Evite to a Halloweenpub crawl, you don’t know the first damn thing about technical tax writing. And of course, they’re right.
Eight years later, two lessons fromResearch andWritingstick with me to this day:
1. It’s where I learned that when writing a tax memo, you have to include everything necessary to support the conclusion, but just as importantly, nothing that doesn’t. The reader doesn’t need to take in a single sentence that’s not germane to the ultimate finding. And second,
2.”Dealer versus investor” issues are a tax advisor’s nightmare. This was the assigned topic for my final paper, and aftersuffering weekly literary de-pantsings at the hands ofmy professor until I finally got it right, I came to realize thatbecause ofthe uncertainty surrounding whether income generated from the sale of certain assets generates ordinary income or capital gain, it often places the tax advisor in a precarious position.
Let’s review: the determination of whether a taxpayer holds a piece of property as inventory or a capital asset is based on all the facts and circumstances. As the courts tend to do in situations like this, they established a test commonly referred to as the “Winthrop Factors.”
The Winthrop Factors aremost oftenapplied in the context of a taxpayer who purchases multiple pieces of property — whether it be undivided raw land, subdivided land, or spec homes — and begins selling them off. The taxpayer, as you might imagine, wants the properties to be treated as investment assets that are capital in nature, with the resulting gain subject to the preferential rates afforded capital gains.
The IRS, on the other hand, routinely argues that the assets are “held for sale in the ordinary course of business,” and thus are excluded from the definition of capital assets by virtue of I.R.C. § 1221(a)(1). As a result, any gain would be characterized as ordinary income.
To determine on which side of the fence particular assets fall, the Winthrop Factors examine the following nine..uh…factors:
(1) the taxpayer’s purpose in acquiring the property;
(2) the purpose for which the property was subsequently held;
(3) the taxpayer’s everyday business and the relationship of the income from the property to the taxpayer’s total income;
(4) the frequency, continuity, and substantiality of sales of property;
(5) the extent of developing and improving the property to increase the sales revenue;
(6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales;
(7) the use of a business office for sale of property;
(8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property; and
(9) the time and effort the taxpayer habitually devoted to sales of property.
Earlier today, the Tax Court got to put the Winthrop Factors to the test in Flood v. Commissioner, T.C. Memo 2012-243. In Flood, the taxpayer was a day trader (read: unemployed) who started buying up vacant lots. Flood would examine public records to determine which property owner to contact in order to purchase the lot, mail the property owner a letter, prepare agreements and deeds, and pay legal fees to clear title and ensure closing.
Once he owned the lots, Flood performed no subdivision of the lots, nor did he construct homes on them. Instead, he simply advertised the lots on a website and in print, before engaging a real-estate agent to help him sell the lots.
From 2001 to 2008, the Floods purchased at least 250 lots. Flood sold two lots in 2004 before selling 40 lots in 2005. On his 2004 and 2005 tax returns, Flood reported a combined capital gain in excess of $1,000,000 from his sale of the lots.
[Ed note: Full disclosure: when I initially read these facts, I presumed that a careful review of the Winthrop factors would reveal that the vacant lots were capital assets, largely by virtue of the complete lack of development activity undertaken by Flood in improving the lots. As is often the case, I was wrong.]
The IRS argued that Flood held the lots as inventory and the gain should be taxed as ordinary income. The Tax Court agreed.
Citing the first factor, the court determined that Flood’s primary purpose for acquiring the lots was to make money by buying the lots at a bargain and reselling them. As evidence, the court noted that although Flood only sold some of the lots he had previously purchased during 2004 and 2005, the gains generated from those sales was “spectacular.” In addition, Flood only sold off his high-value lots, continuing to hold his lots that hadn’t appreciated to the same degree. While I would call this practice “Investment 101,” the Tax Court saw it as evidence that the primary purpose was not to hold the land for investment, but to make a quick profit.
Further incriminating Flood was the fact that his day trading activity wasn’t particularly profitable. Because the income generated from the sale of the real estate was exponentially greater than his stock-trading activity, the court concluded that the sale of the lots was his primary money-making endeavor, not an investment.
In addition, the court concluded that the most important factor — the frequency, continuity, and substantiality of the sales of the lots — weighed against Flood. The two lots sold in 2004 had been purchased in 2003. Of the 40 lots sold in 2005, 11 were purchased in 2001, 15 in 2002, and 12 in 2003. These short holding periods were not indicative of an investment intent.
Lastly, while Flood did not develop the property (factor 5) or use an office (factor 7), the court found that he did devote considerable efforts to the sale of the lots (factor 9) by contacting home owners, drafting agreements, advertising, and using a broker. Again, while I would consider those actions to be the minimum required for a real estate investor, the Tax Court saw it differently.
Ultimately, the court held that the Winthrop Factors weighed against Flood, and the income generated from his sale of the vacant lots was ordinary, rather than capital in nature.
The lesson? Even after 100 years of case law, dealer versus investor issues are still largely a crapshoot. Here, Flood did no subdivision, undertook no improvements, and appeared to perform only the minimum activities necessary to buy and sell the properties, yet the court concluded that the lots were inventory, rather than capital assets. There’s not much more to add, other than if you’re planning to subdivide and sell raw land, be warned.
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