Monday, February 14, 2022
Normally, when a farmer or rancher sells farm or ranch land the resulting gain is treated as capital gain. That’s also the case for an investor in land that later sells it as an investment asset. In both instances, the land is a capital asset that was being used in the seller’s trade or business or as an investment asset. But, once the facts move outside of those confines the tax result can change. For instance, what if urban development was moving toward the farm or ranch and the seller, to take advantage of the upward price pressure on the land, started to parcel out the land and sell it in small tracts? What if the seller had the land platted? What if marketing steps were taken? What if the buyer believed the land had a strategic location at the time of purchase, farmed it for a period of time and then began steps to prepare it to be sold off in smaller residential tracts at substantial gain? Do those factors change the character of the gain? recognized on sale? Possibly.
Sales that are deemed to be in the ordinary course of the taxpayer’s business generate ordinary income. I.R.C. §1221(a)(1). However, the sale of a capital asset (such as land) generates capital gain. The different tax rates applicable to ordinary income and capital gain are often large for many taxpayers (sometimes as much as a 15 percentage-point difference) with the capital gain rates being lower. So, a farmer, rancher or land investor will want to treat the gain from the sale of land as a capital gain taxed at the preferential lower rate. That will be the outcome, unless the land is determined to have been held by the seller for sale to others in the ordinary course of their business.
Farmers and ranchers don’t normally sell land in the ordinary course of their farming or ranching business. As noted above, the determination of the character of gain on sale is fact-dependent, with those facts bearing on the taxpayer’s primary purpose for holding the property. If real estate is acquired for use in the taxpayer’s trade or business or for investment purposes, and retains that character, it is a capital asset, and the gain from sale will receive capital gains treatment. That is a factual determination.
No single factor or combination of factors is controlling. Based on decades of caselaw on the issue, the major factors appear to be as follows: 1) the taxpayer’s purpose in acquiring the property and holding the property before sale; 2) the frequency continuity, regularity and substantiality of sales of real properties; 3) the taxpayer’s everyday business and the relationship of the income from the property to the taxpayer’s total income; 4) the substantiality of sales of real properties; 5) the length of time the taxpayer held the real properties; 5) the extent of the taxpayer’s efforts to sell the property by advertising or otherwise; 6) whether the taxpayer used a business office for the sale of properties; and 7) any improvements the taxpayer made to the real properties to increase sales revenue. See Sovereign v. Comr., 281 F.2d 830 (7th Cir. 1960).
- In Allen v. United States, No. 13-cv-02501-WHO, 2014 U.S. Dist. LEXIS 73367 (N.D. Cal. May 28, 2014), a married couple sold 2.63 acres of undeveloped land that generated over $60,000. They reported the income as capital gain, but the IRS claimed that the income was "other income" taxable as ordinary income. The couple admitted that they bought the land for the purpose of development, and they did attempt to find a partner to develop the property. Ultimately, the property was sold to a developer and the couple received a payment each time a developed portion of the property was sold. The IRS denied capital gain treatment, asserting that the income was from property "held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business."
Note: The term “customers” has been given a broad meaning except in those cases involving taxpayers dealing or trading in securities. Basically, the IRS presumes that in real estate transactions a sale to any purchaser is a sale to a “customer.” See, e.g., Pointer v. Comr., 48 T.C. 906 (1967). The burden is on the taxpayer, based on solid facts, to establish otherwise.
The court noted that the determination of the nature of the income is a fact-based determination, and that the facts supported the IRS. The taxpayers intended to develop and sell the property at the time it was acquired, and the taxpayers were active in getting the property developed. The fact that the property was the only one purchased for development was not determinative. The court granted summary judgment to the IRS.
- A U.S. Tax Court case, Fargo v. Comr., T.C. Memo. 2015-96, involved a partnership that acquired a leasehold interest in a tract of land with the intent to develop an apartment complex and retail space. The lease originally ran for 20 years, but was extended for another 34 years. The property generated only rental income and the taxpayer made no substantial effort to sell the property for 13 years. Ultimately, the property was sold for $14.5 million plus a share of the profits from the homes to be developed on the property. The partnership reported $628,222 of capital gain, but IRS took the position that the transaction triggered $7.5 million of ordinary income. The court agreed with the IRS. The court noted the following factors were important in making the gain characterization distinction: (1) the property was initially acquired for developmental purposes; (2) efforts to obtain financing and continue that development were made; (3) the sale was to an unrelated party with the plan for the petitioner to develop the property; and (4) efforts continued to develop the property up until the purchase date. While there were some factors that favored the taxpayer (only minor improvements were made; there were no prior sales; and no advertising or marketing had been performed), the court held that the factors weighed in the favor of the IRS and the sale was in the ordinary course of business under I.R.C. §1221(a)(1).
- In Long v. Comr., 772 F.3d (11th Cir. 2014), the plaintiff, a real estate developer, entered into a contract with another party to buy land on which the plaintiff was planning on building a high-rise condominium building. The plaintiff hired architects, sought a zoning permit, printed promotional materials about the condominium, negotiated contracts with purchasers of condominium units and obtained deposits for units. However, the seller of the land unilaterally terminated the contract. The plaintiff sued for specific performance and the trial court ordered the seller to honor the contract. While the trial court's decision was on appeal, the plaintiff sold his position as the plaintiff in the contract litigation to a buyer for $5.75 million. The IRS characterized the $5.75 million as ordinary income rather than capital gain. The Tax Court agreed with the IRS on the basis that the plaintiff held the property (which the court said was the land subject to the contract) primarily for sale to customers in the ordinary course of business. On appeal, the court reversed on the basis that the taxpayer never actually owned the land and instead sold a right to buy the land - a contractual right. Accordingly, there was no intent to sell contract rights in the ordinary course of business. The plaintiff intended the contract to be fulfilled and develop the property, and the sale of the right to earn future undetermined income was a capital asset.
- The Tax Court, in SI Boo, LLC v. Comr., T.C. Memo. 2015-19, held that ordinary income and self-employment tax was triggered on sale of properties acquired by tax deeds. The court noted that the taxpayers regularly did this. While they bought the tax liens primary to profit from redemptions of the liens, the court determined that the repeated sales of properties forfeited to them as lien holders constituted ordinary income as a dealer in real estate. They had also hired persons to act on their behalf to acquire the tax deeds, prepare the tracts for sale and maintain business records. The court also held that, under another rule, the income from the sales was not reportable on the installment method.
- Boree v. Comr., 837 F.3d 1093 (11th Cir. Sept. 2, 2016), aff’g., T.C. Memo. 2014-85, involved a taxpayer that was a self-described real estate professional who received income from land sales. The taxpayer reported the income as capital gain, but the Tax Court held that it was ordinary income because the taxpayer was found to have held the property primarily for sale to customers in the ordinary course of the petitioner's real estate business. The court noted that the issue of whether the taxpayer was a developer (ordinary income treatment) or an investor (capital gain treatment) was fact dependent, and that the facts supported developer status. That was the result because he held his business out to customers as a real estate business, and he engaged in development and frequent sales of numerous tracts over an extended period of time. Also, in prior years, he had reported the income from sales as ordinary income and had deducted the expenses associated with the tracts. On appeal, the appellate court affirmed.
The bottom line is that for most sales of farm or ranch land, the income from the sale will be characterized as capital gain. However, with the right (or wrong) set of facts, the sale income could be characterized as ordinary.