Tag Archives: Ordinary income

IRS Court Victory in Capital Gains Case May Help More Taxpayers Than it Hurts

Most capital asset classification cases involve the IRS denying lower-tax-rate capital gain treatment.  Many of these cases turn on whether a taxpayer’s activities relating to the asset were minor enough to avoid becoming an active “business” rather than a more passive activity.

A recent case turned that pattern on its head, with a taxpayer claiming a real estate asset he intended to redevelop was a business asset, not a capital asset, so he could deduct a loss on its sale against other ordinary income.  The IRS argued the taxpayer didn’t sell real estate frequently enough to make his activity a business.  The IRS further argued the loss should be a capital loss that is not deductible against other ordinary income.

The Tax Court agreed with the IRS.  In its opinion, notwithstanding the taxpayer’s primary occupation as an employee of a real estate development company,  the Tax Court ignored the possibility that the taxpayer could be in the business of developing property himself.  The court instead focused solely upon whether he frequently personally purchased and sold property.

The taxpayer’s infrequent personal real estate dealings helped the IRS disallow a loss in this case; however, the Tax Court’s reasoning could be beneficial to other taxpayers with gains.  For example, it could help persons who occasionally develop property—such as a spec home–as a non-primary activity in claiming lower-tax-rate capital gain treatment.  In the end, more taxpayers may benefit from this decision than are hurt.

Here is a link to the Tax Court’s Memorandum Opinion in Evanshttp://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=10655

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

IRS Procures a Document Scanner, Simplifies Section 83(b) Elections

Having procured a document scanner, IRS has eliminated the requirement that taxpayers enclose Internal Revenue Code Section 83(b) elections with their income tax returns. When a taxpayer receives property (such as stock or LLC interests in an employer) in exchange for services, the taxpayer normally recognizes the fair market market value of the property as ordinary (regular tax rate) income in the year the property is transferable or is vested (i.e., not subject to forfeiture). A taxpayer can, however, accelerate recognition of income by filing a Section 83(b) election with IRS within thirty days of receiving the property. By doing so, the taxpayer can recognize the property’s value as ordinary income when first granted (when the value may be low) and start his or her long-term capital gain holding period sooner (so the taxpayer is more likely to recognize lower-tax-rate long-term capital gain on a larger portion of gain when the property is later sold). Previously, a Section 83(b) election was valid only if a copy was enclosed with the taxpayer’s income tax return for the year of the election, in addition to filing the election within thirty days of receiving the property. IRS required this because they could not match originally-filed elections with taxpayer tax returns. The absolute rule unfortunately proved a frequent trap for unorganized taxpayers who forgot to include the elections with their tax returns, even though they timely filed original elections. In recent years, some commercial electronic tax filing services had difficulty creating a means for their customers to include Section 83(b) elections with electronically filed returns. This caused some taxpayers to file paper income tax returns just to make sure their Section 83(b) elections were valid. In response to concerns surrounding this issue, IRS created a document scanning process that enables the agency to better match Section 83(b) elections with taxpayer returns, obviating the need to include the elections with taxpayers’ income tax returns. Document scanning is not a new technology. It is disappointing that common sense did not prevail long ago. The taxpayer “trap” has existed for years, but the “fix” only came about when the process became an administrative hassle for IRS. Nevertheless, the new approach is a positive step in tax administration, and we welcome the change. Here is a link to the Proposed Treasury Regulations, effective January 1, 2015: http://www.gpo.gov/fdsys/pkg/FR-2015-07-17/pdf/2015-17530.pdf

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Some Tax-Motivated Couples Don’t Marry Under the Law, Even If They Are Bound In Their Hearts

The Supreme Court’s decision authorizing nationwide same-sex marriage further extends marital rights. But some extraordinarily-tax-motivated same-sex couples may make the same choice that some opposite-sex couples have made for years, to avoid marriage to take advantage of tax planning opportunities married couples cannot.

Marriage brings with it many tax benefits, especially under the federal income tax for families of all income levels with a single wage earner, and under the federal estate and gift tax, where even wealthy spouses are allowed unlimited tax-free transfers between themselves. But married couples are also treated as “related parties” under the Internal Revenue Code. Related party treatment prevents spouses from engaging in many tax motivated transactions that unmarried persons—even those who for all practical purposes function like a married couple—cannot.

For example, unmarried persons who co-own a corporation can more freely engage in redemption transactions in which their corporate share income tax basis offsets distribution income. Married couples are more restricted in this regard. Unmarried persons can buy and sell property between themselves free of related-party rules that re-characterize lower-tax long-term capital gain as higher-tax-rate ordinary income or prevent the purchaser from re-depreciating purchased assets. Members of unmarried couples can serve as counterparties in tax-deferred 1031 exchanges, whereas married couples are restricted in this regard.

The number of persons who would avoid marriage for tax reasons is limited. In our experience, however, some individuals—particularly those with substantial real estate holdings–take these tax planning opportunities into account when deciding whether to marry under the law, even if they are committed in their hearts. Those taxpayers turn Congressional policy on its head, causing tax laws intended to prevent abusive tax avoidance by closely connected individuals into an unintended deterrent to marriage.

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Real Estate Investor Forced to Recognize Ordinary Business Income Instead of Capital Gain, Despite Holding Property Without Physical Improvement For Over a Decade

Sometimes it’s what you say, not what you do, that matters. A taxpayer learned that the hard way in a recent United States Tax Court decision.

There are numerous court decisions in which a taxpayer acquired property, incurred “soft costs” to entitle the property for future development, and then recognized capital gain (not higher-tax ordinary income) on the sale of the property. In these cases, the taxpayer did not physically improve the property, and the taxpayer by resolution, agreement, prior tax reporting, or other independent means expressed an intent to sell the property before physical improvement occurred. Amongst other factors, the combination of an expressed non-development intent with the actual lack of physical improvement was sufficient to preserve capital gain treatment, and to prevent the taxpayer’s activities from becoming a more active “business” subject to higher ordinary income tax rates. This sometimes has been true even when the taxpayer sells the property to another company with common ownership, which then develops the property.

The recent Tax Court decision emphasizes that the expression of intent is essential to preserving capital gain qualification, even if property is never developed or improved. In the case, the taxpayer originally intended to develop the property. The taxpayer incurred soft costs to prepare the property for development, but then held the property for over a decade without physically improving it. The taxpayer rented and occupied the property as office space, uses usually considered capital gain-qualifying activities. The Tax Court nevertheless held that the absence of evidence the taxpayer abandoned its initial development intent was sufficient to distinguish the case from others in which taxpayers engaged in the same activities, but specifically expressed non-development investment intent to third parties.

While the decision seems harsh, it is a reminder that the characterization of a taxpayer’s activities in partnership or operating agreements, resolutions, business coding on tax returns, and other third-party pronouncements is essential to protecting capital gain qualification, even if a taxpayer never physically develops property.

Here is a link to the United States Tax Court decision in Fargo v. Commissioner:
http://www.ustaxcourt.gov/InOpHistoric/FargoMemo.Goeke.TCM.WPD.pdf

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Can Developers Recognize Long-Term Capital Gain By Selling Land They Don’t Own? Maybe, at Least in Florida, Georgia, and Alabama

Reversing the US Tax Court, the US Court of Appeals for the Eleventh Circuit recently held that a real estate developer recognized long-term capital gain when he sold contractual purchase rights in real estate, even though the developer previously intended to develop and resell the underlying real estate as condominiums. The Court found that contractual purchase rights could be a capital asset even though the real estate itself would have become ordinary income generating inventory property had the developer closed the purchase contract instead of selling it. As a result, the developer’s effective tax rate was probably reduced by approximately 20%.

The case bolsters some capital gain preservation tax strategies. It does not, however, provide a blank check to lock in capital gain tax rates by trading in contracts rather than land. A few warnings:

First, the circumstances of the sale deviated from the developer’s original plan. While the Court’s reasoning is not entirely clear, the Court observed that the developer did not originally intend to sell the contractual rights. Instead, the developer originally intended to close on the contract, purchase the real estate, and develop condominiums for resale. The tax result could be different if the developer planned all along to sell the purchase contract itself.

Second, the Eleventh Circuit is a federal appellate court immediately below the Supreme Court, with jurisdiction over Florida, Alabama, and Georgia. It is unlikely the Supreme Court will hear this case. While other federal courts with jurisdiction elsewhere might find the Eleventh Circuit’s decision persuasive, they could reach different conclusions. The Tax Court reached a different conclusion in the same case. The Eleventh Circuit’s conclusion is most helpful to taxpayers subject to the Eleventh Circuit’s appellate jurisdiction. Other taxpayers face greater risks relying on the Eleventh Circuit’s decision.

Here is a link to the Eleventh Circuit’s opinion in Long v. Commissioner:
http://media.ca11.uscourts.gov/opinions/pub/files/201410288.pdf

Here is a link to the Tax Court’s decision in the same case, which the Eleventh Circuit reversed on this issue:
http://www.ustaxcourt.gov/InOpHistoric/longmemo.morrison.TCM.WPD.pdf

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

A Proposal to Better Protect Capital Gains for Real Estate Investors Before Development

We have discussed a structuring technique real estate investors use to protect the lower-federal-income-tax-rate-long-term-capital-gain treatment of real estate gains, before property is converted to an active development purpose that creates higher-tax-rate income. The structuring requires property transfers and the use of multiple business entities, which decreases transparency for the government and is difficult for taxpayers to implement.

A “check-the-box” tax election that allows taxpayers to achieve the same tax result would better serve the interests of all involved. I am co-author of a new Florida Tax Review article proposing such an election. Here is a link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2439888

The following provides a broader overview of the structuring technique allowed under current law: Check the Box Bramblett – ABA Tax SEB Committee Presentation

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Protect Capital Gains for Real Estate Investors Before Development

In January we noted a new Tax Court case, Pool v. Commissioner, addressing the boundaries of a structuring technique real estate investors use to protect the lower-federal-income-tax-rate-long-term-capital-gain treatment of real estate gains, before property is converted to an active development purpose that creates higher-tax-rate income. Tax Court Sets Boundaries For Predevelopment Capital Gains For Real Estate Developers

Here is a link to materials from the American Bar Association Tax Section meeting in Washington this month, discussing the case in more detail: Pool v Commr ABA SEB Committee Presentation (May 10 2014)

The following provides a broader overview of the structuring technique: Check the Box Bramblett – ABA Tax SEB Committee Presentation

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Tax Court Sets Boundaries for Predevelopment Capital Gains for Real Estate Developers

A recent Tax Court case, Pool v. Commissioner, is the first court opinion in many years describing the limits of a popular capital gain tax planning technique used by real estate investors and developers.
Continue reading