Originally published on Passive Activities and Other Oxymorons on December 15, 2010
Wendell V. Garrison, et ux. v. Commissioner, TC Memo 2010-261
This case addresses an important issue that I run into from time to time. How do you distinguish between investing in real estate or acquiring for use in a trade or business as opposed to being in the business of buying and selling real estate ? If you are a pure investor your gain on sale will be capital gain, your loss will be capital loss and your expenses will be itemized deductions subject to a variety of limitations depending on which ones we are talking about. If you are holding the property as a rental your gain will be a capital gain (with gain attributable to accumulated depreciation subject to a special rate) and your deductions will go against adjusted gross income. If you have a net loss, it may be suspended by the passive activity loss rules. Loss on the sale of a rental property is ordinary. If you are in the business of buying and selling real estate all income and loss is ordinary and subject to self employment tax.
There is, of course, more to it than that. Investors and rental property holders can do tax deferred like-kind exchanges. Someone in the business of buying and selling can shelter some their income with a Keogh or SEP or something like that. Not that they ever will. Real estate flippers will only stop when they die or own all the real estate in the world (I used to include bankruptcy as another end point, but that is really just a brief interruption). I am also leaving out owning the real estate involved in a business that you operate. Frequently that ends up being a rental situation, although there are some special rules.
Wendell and Sharon Garrison filed returns that fell somewhere between investor and rental operation. They didn't claim any operating expenses, but reported sales of property on Form 4797, which is the form for reporting sale of assets used in a trade or business (which for this purpose includes rental). They claimed capital gain treatment. Since most of the sales were short term I wonder what difference this made. It can make a big difference to someone who has capital loss carryovers, but based on the rest of the facts that didn't seem that likely. More significantly they did not pay self-employment tax on their earnings.
It seems like Mr. Garrison, more or less, shot himself in the foot:
Petitioner husband testified: “I'm in the business of buying material, fixing houses and reselling them.”
Still the court got into the factors to consider.
Typically, the factors in making this determination include:
(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 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 the sale of property;
(8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property;
(9) the time and effort the taxpayer habitually devoted to the sales.
Petitioners engaged in at least 15 sales over 3 years, and most of the sales occurred within 4 months after they purchased the property.
That pretty much summed it up. The case also got into substantiation of expenses. They had nothing so the additional expenses they claimed were not allowed. The Cohan Rule was not even mentioned.
My own rough guideline in this area is that when you do your third renovation sale your in the business of buying and selling property, particularly if the first two did not have any rental activity. If you are doing this to scale it is worth consulting the Phelan decision (Timothy J. Phelan, et ux. v. Commissioner, TC Memo 2004-206). By isolating different activities in different entities it is possible to get capital gains treatment on some of the economic return from a development even though related entities might be doing ordinary income type activities. In order for this type of thing to work though it is critical that the entities be treated with respect. As with family limited partnerships, the devil is in the details.