Last week’s post considered the risk assumed by a taxpayer that ignores the plain meaning of a Code provision (the definition of “capital asset”) in favor of a more “rational” – favorable? – interpretation of that provision.

capital assets

This week’s post considers the “plain meaning” of the same section of the Code: the definition of the term “capital asset;” in particular, how one well-advised taxpayer was able to establish, through contemporaneously prepared documents, that they had changed the nature of their relationship to the property at issue.

Why does it Matter?

The Code provides that the gain recognized by an individual from the sale of a “capital asset” held for more than one year shall be taxed as long-term capital gain, at a maximum federal income tax rate of 20%.

It also provides that the gain from the sale of real property used by an individual taxpayer in a “trade or business,” held for more than one year, and not “held primarily for sale in the ordinary course of the taxpayer’s trade or business,” shall be treated as long-term capital gain.

Thus, if real property does not represent a capital asset in hands of an individual taxpayer, and it is held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, the gain from the sale of the property shall be taxed to the taxpayer as ordinary income, at a maximum federal rate of 37%.

Poor Timing

LLC was formed in the late 1990’s to acquire several contiguous tracts of land (the “Property”), and to develop them into residential building lots and commercial tracts.

The Property was adjacent to other properties that were being developed by other business entities, related to LLC, and LLC’s original plan was to subdivide the Property into residential units for inclusion in the related entities’ development. To that end, LLC entered into a development agreement with City, which specified the rules that would apply to the Property should it be developed.

LLC sold or otherwise disposed of some relatively small portions of the Property, retaining three main parcels for development.

Change in Plans?

As a result of the subprime mortgage crisis, however, LLC’s managers decided that LLC would not attempt to subdivide or otherwise develop the Property. They believed that LLC would be unable to develop, subdivide, and sell residential and commercial lots from the Property because of the effects of the subprime mortgage crisis on the local housing market, and the unavailability of financing for such projects in the wake of the financial crisis.

Instead, they decided that LLC would hold the Property as an investment until the market recovered enough to sell it off. These decisions were memorialized, on a contemporaneous basis, in a written “unanimous consent” that was dated and executed by the managers, as well as in a written resolution that was adopted by the members of LLC to further clarify LLC’s policy.

Thus, between 2008 and 2012, LLC did not develop the three parcels in any way, nor did it list them with any brokers, or otherwise market the parcels.

The Sale

In 2011, an unrelated developer (“Developer”) approached LLC about buying the parcels. LLC sold one of the parcels to Developer in 2011 and the other two in 2012.

One of the sale contracts called for Developer to pay a lump sum to LLC in 2012 for two of the parcels. The contract also listed certain development obligations, almost all of which fell on Developer.

LLC’s Forms 1065, U.S. Return of Partnership Income, for 2012 – and, indeed, for all years – stated that its principal business activity was “Development” and that its principal product or service was “Real Estate”. On its 2012 Form 1065, LLC reported $11 million of capital gain from its sale of one parcel and a $1.6 million capital loss from its sale of the second parcel, and this tax treatment was reflected on the Schedules K-1 issued by LLC to its individual members.

IRS Disagrees

The IRS determined that the aggregate net income from these two sale transactions should have been taxed as ordinary income.

The issue presented to the Tax Court was whether LLC’s sales of the two parcels in 2012 should have been treated as giving rise to capital gains or ordinary income.

The Court began by reviewing the Code’s definition of capital asset: “property held by the taxpayer (whether or not connected with his trade or business),” but excluding “inventory” and “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

Factors to Consider

The Court stated that the three principal questions to be considered in deciding whether the gain is capital in character are:

a. Was taxpayer engaged in a trade or business, and, if so, what business?
b. Was taxpayer holding the property primarily for sale in that business?
c. Were the sales contemplated by taxpayer “ordinary” in the course of that business?

The Court also indicated that various factors may be relevant to these inquiries, including the:

i. Frequency and substantiality of sales of property (which the Court noted was the most important factor);
ii. Taxpayer’s purpose in acquiring the property and the duration of ownership;
iii. Purpose for which the property was subsequently held;
iv. Extent of developing and improving the property to increase the sales revenue;
v. Use of a business office for the sale of property;
vi. Extent to which the taxpayer used advertising, promotion, or other activities to increase sales; and
vii. Time and effort the taxpayer habitually devoted to the sales.

Original Intent

The parties agreed that LLC was formed to engage in real estate development; specifically, to acquire the Property and develop it into residential building lots and commercial tracts; LLC’s tax returns, City’s development agreement, LLC’s formation documents, and the testimony of its managers, all showed that LLC originally intended to be in the business of selling residential and commercial lots to customers.

Change in Purpose

But the evidence also clearly showed that, in 2008, LLC ceased to hold the Property primarily for sale in that business, and began to hold it only for investment. LLC’s members decided not to develop the parcels any further, and they decided not to sell lots from those parcels. This conclusion was supported by the testimony of its managers, by their 2008 unanimous consent, and by the members’ resolution. Moreover, from 2008 on, LLC in fact did not develop or sell lots from the Property until 2012.

More particularly, when the main parcels were sold, they were not sold in the ordinary course of LLC’s business:

a. LLC did not market the parcels by advertising or other promotional activities;
b. LLC did not solicit purchasers for the parcels, nor did its managers or members devote any time or effort to selling the property;
c. Developer approached LLC; and
d. Most importantly, the sale of the parcels was essentially a bulk sale of a single, large, and contiguous tract of land to a single seller – clearly not a frequent occurrence in LLC’s ordinary business.

Court Disagrees with the IRS

Because the parcels were held for investment and were not sold as part of the ordinary course of LLC’s business, the Court rejected the IRS’s arguments and held that the net gain from the sales was capital in character.

The IRS argued that the extent of development of the parcels showed that they were held primarily for sale in the ordinary course of LLC’s business. The Court conceded that, from 1998 to sometime before 2008, LLC developed the Property to a certain extent. But it was also clear that, in 2008, LLC’s managers decided not to develop or market the Property as they ordinarily would have.

The Court stated that a taxpayer is “entitled to show that its primary purpose changed” from held-for-sale to held-for-investment. The Court concluded that LLC made such a showing. Any development activity that occurred before the marked change in purpose in 2008 (including whatever was reported on LLC’s earlier returns) was largely irrelevant.

The IRS also argued that the frequency of sales, along with the nature and extent of LLC’s business, showed that gains from the sale of the parcels should be ordinary in character. But LLC’s sales were infrequent, the Court observed, and the extent of its business was extremely limited. After 2008, LLC disposed of the entire Property in just nine sales over eight years (most of which were small sales to related entities). Moreover, the main parcels, sold in 2012, had not been developed into a subdivision when they were sold, and little or no development activity occurred on those parcels for at least three years before the sale.

In sum, after 2008, LLC sold most of its undeveloped Property in a single transaction to a single buyer, Developer, and sold the remainder to related parties.

The IRS suggested that the Court should impute to LLC the development activity which was performed by the parties related to LLC on the other property contiguous to the Property. The IRS did not provide the Court with any legal authority or evidence in support of this position. But, the Court continued, even if one assumed that LLC engaged in substantial development activity on, or in active and continuous sales from, these parcels (by imputation or otherwise), nevertheless – in the absence of a connection between those other parcels and the parcels sold in 2012 – the Court was not persuaded that the bulk sale of the parcels to Developer would have been in the ordinary course of LLC’s alleged development business, considering that all development activity had been halted on these parcels at least three years before the sales at issue and that these parcels were never developed into a subdivision by LLC.

The Court noted, “if a taxpayer who engaged in a high volume subdivision business sold one clearly segregated tract in bulk, he might well prevail in his claim to capital gain treatment on the segregated tract.” That is precisely what happened here, the Court stated; the parcels sold were clearly segregated from the other parcels and were sold in bulk to a single buyer.

Still the IRS argued that the sale generated ordinary income because: the parcels were covered by the development agreement with the City; Developer agreed to develop the parcels; and LLC was to receive certain post-sale payments from Developer whenever certain conditions were met.

The Court found that these facts were either irrelevant or were consistent with investment intent. For example, there would have been no reason for LLC to undo or modify the development agreement with City after deciding not to develop the parcels. There seemed to be little doubt that the highest and best use of the Property was for development into residential and commercial lots. Any buyer would likely have been a developer of some kind. Therefore, the Court continued, maintenance of the development agreement was consistent with both development intent and investment intent.

Next, the IRS pointed out that, on its 2012 Form 1065, LLC listed its principal business activity as “Development” and its principal product or service as “Real Estate”. (Ugh!) Although this circumstance may count against taxpayers to some limited degree, the Court believed that these statements “are by no means conclusive of the issue.” Considering the record as a whole, the Court was inclined to believe that these “stock descriptions” were inadvertently carried over from earlier returns.

Finally, the IRS asserted a schedule of LLC’s capitalized expenses showed that LLC “continued to incur development expenses up until it sold” the land to Developer. But the Court accorded these little weight because the record as a whole clearly showed that the parcels were not developed between 2008 and the sale to Developer. Also, most of the post-2008 expenditures on the schedule of capitalized expenditures were consistent with investment intent.

Therefore, the Court concluded that LLC was not engaged in a development business after 2008 and that it held the two parcels as investments in 2012. Accordingly, LLC properly characterized the gains and losses from the sales of these properties as income from capital assets.


There is no doubt that, as in the case of LLC, a taxpayer’s purpose in holding certain property may change over time, thus affecting the nature of the gain recognized by the taxpayer on the sale of the property.

Of course, the taxpayer has the burden of establishing their purpose for holding the property at the time of the sale. A well-advised taxpayer will seek to substantiate such purpose well before the IRS challenges the taxpayer’s treatment of the gain recognized from the sale.

Indeed, if the taxpayer has, in fact, decided to change their relationship to the property, they should document such change contemporaneously with their decision – while the facts are still fresh and the decision-makers are still alive – including the reasoning behind it, whether as a result of a change in economic conditions, a change of business, or otherwise.

Moreover, they should reflect such change in their dealings with the property and throughout their subsequently filed tax returns. Why give the taxing authorities an easy opening on the basis of which to wrest an unnecessary concession?