What is the Character of Land Sale Gain?

Overview

When land is sold, is the gain on sale taxed as capital gain (preferential rate) or as ordinary income?  As with most answers to tax questions, the answer is that “it depends.”  Most of the time, when a farmer or ranchers sells land, the gain will be a capital gain.  But, there can be situations where the gain will be ordinary in nature – particularly when farmland is subdivided or sold off in smaller tracts.  That’s a technique, by the way of some farm real estate sellers, especially in the eastern third of the United States.   It's also becoming a more popular technique for farmland to be strategically purchased as an investment asset given the economic downturn and poorer returns from stock market investments.  Does selling the land in smaller tracts, or subdividing it create ordinary gain rather than capital gain?  What about buying a tract in the path of future urban development and holding it for purposes of later sale at an appreciated price?

A couple of recent cases illustrate the issue of what a capital asset is and the safe harbor that can apply when land is sold that has been subdivided or sold off in smaller tracts.

The character of gain on sale of land and a possible “safe harbor” – that’s the topic of today’s post. 

What Is A Capital Asset?

I.R.C.§1221(a) broadly defines the term “capital asset” as all property held by the taxpayer.  Eight exceptions from that broad definition are provided.  The first exception, I.R.C. §1221(a)(1), states that property that is either inventory or like inventory cannot qualify as a “capital asset.” In particular, I.R.C. §1221(a)(1) says a capital asset does not include “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”  Whether a landowner is holding land primarily for sale to customers depends on the facts. As the U.S. Circuit Court of Appeals for the Tenth Circuit put in in the classic case of Mauldin v. Commissioner, 195 F.2d 714 (10th Cir. 1952), “There is no fixed formula or rule of thumb for determining whether property sold by the taxpayer was held by him primarily for sale to customers in the ordinary course of his trade or business. Each case must, in the last analysis, rest upon its own facts.”  The Fifth Circuit has said essentially the same thing in Suburban Realty Co., v. United States, 615 F.2d 171 (5th Cir. 1980). 

Subdividing Real Estate

When property is subdivided and then sold, the IRS may assert that the property was being held for sale to customers in the ordinary course of the taxpayer’s trade or business.  If that argument holds, the gain will generate ordinary income rather than capital gain.  However, there is a Code provision that can come into play.  I.R.C. §1237 provides (at least) a partial safe harbor that allows a taxpayer “who is not otherwise a dealer”… to dispose of a tract of real property, held for investment purposes, by subdividing it without necessarily being treated as a real estate dealer.”  If the provision applies, the taxpayer is not treated as a “dealer” just simply because the property was subdivided in an attempt to sell all or a part of it.  But, the safe harbor only applies if there is a question of whether capital gain treatment applies.  If capital gain treatment undoubtedly applies, I.R.C. §1237 does not apply.  See, e.g., Gordy v. Comr., 36 T.C. 855 (1961). 

What is a “dealer”?  It’s not just subdividing land that can cause a taxpayer to be a “dealer” in real estate with gains on sale taxes as ordinary income.  That’s the result if the taxpayer is engaged in the business of selling real estate; holds property for the purpose of selling it and has sold other parcels of land from the property over a period of years; or the gain is realized from a sale in the ordinary operation of the taxpayer’s business.  In addition, it’s possible that a real estate dealer may be classified as an investor with respect to some properties sold and capital gains treatment on investment properties.  But, as to other tracts, the dealer could be determined to be in the business of selling real estate with the sale proceeds taxed as ordinary income.  See, e.g., Murray v. Comr., 370 F.2d 568 (4th Cir. 1967). 

The “Safe Harbor”

I.R.C. §1237 specifies that gain from the sale or exchange of up to five lots sold from a tract of land can be eligible for capital gain treatment.  Sale or exchange of additional lots will result in some ordinary income.  To qualify for the safe harbor, both the taxpayer and the property must meet the requirements of I.R.C. §1237 and make an election to have the safe harbor apply.  For the taxpayer to qualify for the election, the taxpayer cannot be a C corporation.  Presumably, an LLC taxed as a partnership would qualify.  For property to qualify, it must have not previously been held by the taxpayer primarily for sale to customers in the ordinary course of business; in the year of sale, the taxpayer must not hold other real estate for sale as ordinary income property; no substantial improvement that considerably enhances the property value has been made to the property (see I.R.C. §1237(b(3); Treas. Reg. §1.1237-1(c)); and the taxpayer must have held the property for at least five years.  I.R.C. §1237(a).

If the requirements are satisfied, the taxpayer can elect to have the safe harbor apply by submitting a plat of the subdivision, listing all of the improvements and providing an election statement with the return for the year in which the lots covered by the election were sold.     

Recent Cases

Sugar Land Ranch Development, LLC v. Comr., T.C. Memo. 2018-21.  In Sugar Land, the taxpayers formed a partnership in 1998 to buy and develop land outside of Houston for the purpose of turning that land into housing developments and commercial developments. The partnership acquired various parcels of land totaling about 950 acres. The land had been a former oil field and so over the years the partnership cleaned up the land, built a levee, and entered into a development contract with the city of Sugar Land, Texas to set up the rules for developing the lots.  All of this sounds like the characteristics of a “developer” doesn’t it?

By 2008, the partnership had done a lot of work developing the land.  But, then the downturn in the real estate market hit and the partnership stopped doing any more work.  It wasn’t until 2012 that the partnership sold any significant part of the land. In that year it sold two parcels (about 530 acres) to a homebuilding company.  The homebuilding company paid a lump sum for each parcel, and also agreed to make future payments relating to the expected development.  A flat fee was paid for each plat recorded, and the homebuilding company paid two percent of the final sales price of each house developed on one of the parcels.

The partners entered into a “Unanimous Consent” dated December 16, 2008, declaring that the partnership would no longer attempt to develop the land but would instead hold the land until the real estate market recovered enough to sell at a profit.

The partnership reported an $11 million gain from the sale of one parcel and a $1.6 million loss on the other parcel. It took the position that the land sold was a “capital asset” and so the gains and losses were capital gains and losses.  The IRS disagreed.  After all, it pointed out that the partnership acquired the property to develop it and merely delayed doing so because of the economic downturn.

Ultimately, the Tax Court agreed that the partnership had successfully changed its operations after 2008 from “developer” to “investor” such that the land it sold in 2012 was a capital asset and the gain was a capital gain.  That made a big bottom-line tax difference.

Observation:  The partnership in Sugar Land Ranch Development, LLC never actually subdivided the property at issue into separate lots, and the IRS still claimed it was acquired and held for development purposes.  While capital gain classification is based on a facts and circumstances test, subdividing land for sale doesn’t necessarily mean that it’s no longer a capital asset.  That’s the point of I.R.C. §1237 and the safe harbor.  In addition, the facts can cause the reason for holding property to change over time.  That, in turn, can change the tax result. 

Musselwhite v Comr., T.C. Memo. 2022-57.  In Musselwhite, the petitioner had been involved in real estate ventures since the mid-1980’s.  In 2005, the petitioner and his business partner formed an LLC.  In 2006, the LLC bought four unimproved lots for $1 million and re-platted them into nine lots.  The terms of the sale agreement included certain guarantees-of-resale-within-one-year, allocation of ownership of the nine lots between the parties with the seller allocated five lots.  The sales agreement also included buy-back provisions and other conditions related to development and sale of the lots.  The seller was to complete improvements on some of the lots. The petitioner financed the purchase of the lots via a loan from a bank. 

In 2007, the real estate market collapsed.  Because the seller didn’t make promised improvements and also because of the lack of sales, the LLC sued the seller.  To settle the suit, the seller transferred his partially improved lots to the petitioner.  The LLC made no further improvement to those lots.  The bank’s later appraisals indicated that the lots were not known to be for sale.  The LLC divided up the lots and the existing debt and distributed four of the lots to the petitioner.  Within four months, the petitioner sold the lots at a loss of $1,022,726 and reported a Schedule C deduction of $1,022,726 as cost of goods sold.  The IRS disagreed, characterizing the loss as a capital loss because the lots were, in the IRS view, capital assets. 

The Tax Court agreed with the IRS that the lots were capital assets and did not meet the definition of stock in trade under I.R.C. §1221(a)(1) that would either be held in inventory or held primarily for sale to customers in the ordinary course of business.  The Tax Court noted that the distinction between a capital asset and one held for sale to customers in the ordinary course of business is a fact question.  Those factors in the Fourth Circuit (the Circuit to which the case would be appealable) include: 1) the purpose for which the property was acquired; 2) the purpose for which the property was held; 3) improvements, and their extent, that the taxpayer made to the property; 4) the frequency, number and continuity of sales; 5) the extent and substantiality of the transaction; 6) the nature and extent of the taxpayer’s business; 7) the extent of advertising of lack thereof; and 8) the listing of the property for sale directly through a broker.  The Tax Court noted that no single factor is determinative, but that the factors overwhelmingly favored the IRS. 

Observation:  In Musselwhite, the Tax Court also noted that the reason a taxpayer holds real estate can change if, for example, the taxpayer develops investment property to prepare it for sale.  Also, the Tax Court pointed out that I.R.C. §735(a)(2) provides that gain or loss on the sale or exchange by a partner of inventory items distributed to the partner by the partnership is ordinary income/loss if the items are sold or exchanged within five years from the date of distribution. 

Conclusion

In the vast majority of situations when a farmer or rancher sells farmland, the sale will qualify for capital gain treatment.  However, there can be situations where ordinary income treatment can be the result.  In difficult economic times such as the present, farm and ranch land might be a decent investment hedge against inflation.  Investment in land that isn’t really used in the farming or ranching business might raise IRS “eyebrows” upon sale with an assertion that the gain on sale is ordinary in nature.