Do any you have some land that you are thinking about selling in 2015 for a large capital gain under IRS Section 1221 to perhaps be offset against some stock losses in your brokerage account? Seems easy enough. But unfortunately the Government looks closely at your land sales when the IRS in many cases years later commences a Capital Gain to Ordinary Income Audit disallowing all your capital gain and converting those gains to ordinary income under IRS Section 61. When the audit is over, the IRS agent then explains to you that you owe a great deal of tax, interest and penalty now that your brokerage capital losses cannot offset ordinary income. So how do you protect your capital gain from converting to ordinary income when the IRS comes knocking on your door? Stay with us here on TaxView with Chris Moss CPA Tax Attorney to find out how to bulletproof your capital gain from an IRS Capital Gain to Ordinary Income Audit.
Selling land, real estate or stock always results in a capital gain right? Well not quite always as is currently trending in 2015 and as Greg and Melanie Boree discovered in Boree v IRS US Tax Court (2014). The facts are simple. Boree purchased 1,982 acres in Florida with a 1.8M loan from Perkins State Bank in 2002, plans were submitted to the County and various lots were sold during the next 5 years. However, in 2007 a new investor Adrian Development purchased 1067 acres for $9,600,000 from Boree.
Boree recorded all lot sales from 2005, 2006 and 2007 on his income tax form 1040 Schedule C as ordinary income but the sale in 2007 to Adrian as long term capital gain. The IRS came visiting in 2011 and commenced a Capital Gain to Ordinary Income Audit, disallowing the entire capital gain resulting in a tax bill of almost $2M. Boree appealed to US Tax Court in Boree v IRS US Tax Court (2014).
Judge Foley cuts right to the core issue: Was the $9.6M sale of land part of inventory of a business or was this sale unique, different from the other sales to be treated as a capital asset held for investment. The Court notes that sales of lots were made to customers in the normal course of business from 2002 to 2007 and were frequent and substantial with no distinction made in the books and records to treat the Adrian sale any differently, citing Slappey Drive Industrial Park v US 561 F.2d 572 (5th Cir 1977). Indeed the Court concluded there was no evidence presented contemporaneously by Boree in his 2007 tax return that the Adrian sale was being considered for tax purposes “segregated from the rest of the property” as property held for investment. IRS Wins Boree Loses.
Timothy and Deborah Phelan had a very different experience in Phelan v IRS US Tax Court (2004) when the IRS came knocking on their door for a Capital Gains to Ordinary income audit. The facts are very complex so I have simplified as best I could as follows: Phelan purchased 1050 acres in Colorado in 1994 with possible plans for development. There were various agreements with the County, municipal town and other developers but no sales to the public. In 1998, Phelan sold 45 acres were sold to Elite Development and Vision Development for $1.5M and recognized a 1998 capital gain on his personal tax return. The IRS commenced a Capital Gain to Ordinary Income Audit and converted the capital gain to Ordinary income claiming that Phelan was in the business of selling real estate. Phelan appealed to US Tax Court in Phelan v IRS US Tax Court (2004) claiming he had no employees nor did he engage in any business activities outside of holding and selling a limited number of parcels with the ultimate hope of appreciation of the value of the land.
Judge Gerber easily finds for Phelan because the facts showed that other than the 2 sales in 1998 there was no other activity. The Court concluded that during the 4 years that Phelan held the land, the property did in fact appreciate according to plan and the investment goals had indeed been achieved by Phelan. Phelan wins IRS Loses.
Our final case involves Frederic and Phyllis Allen who in 1999 sold 2.63 acres of undeveloped real estate in East Palo Alto to property developer Clarum Corporation. He reported the sale as an installment sale as per the sales agreement with Clarum and in 2004 Allen received the final installment of $63K from Clarum. Allen did not report this income on his 2004 tax return. On advice of tax professionals Allen amended his 2004 return in 2008 reporting the $63K as long term capital gain. The IRS audited Allen’s amended return and converted the capital gain to ordinary income after an IRS Capital Gain to Ordinary Income Audit. Allen bypassed US Tax Court by paying the tax and then suing for a refund in US Federal District Court for the Northern District of California in Allen v US No 3.2013cv02501.
Judge William Orrick opines that the evidence is compelling that Allen intended to develop the property when he purchased the property and that he undertook substantial efforts to develop the property during the time he owned it. Even Allen in his own deposition indicated to the Court that his original intent was to develop the property. While Allen then argues to the Court in that same deposition that his intent changed over time, the Court found that Allen presented no credible evidence to prove that his intent changed, citing Tibbals v US 362 F.2d 266 (Ct Cl 1966). The Tibbals Court held that a taxpayer’s purpose can change based on the facts the taxpayer presents to the Court but Judge Orrick in Allen concluded that because Allen provided no evidence that he had held the land for anything other than development the sale of the property therefore resulted in ordinary income. IRS Wins, Allen loses.
So for anyone out there planning to buy land, real estate or some other capital asset what can you do right now to protect your long term capital gain from ordinary income conversion when the IRS Capital Gain to Ordinary Income Audit commences years from now. First before you purchase your land have your tax attorney contemporaneously create the facts and evidence you will need to win an IRS Capital Gain to Ordinary Income Audit. Tibbal makes clear you need to prove to the Court that the purpose for which the property was acquired, the motive for selling it, the taxpayer's method of selling the land, taxpayer’s income from the sale of it compared with his other income, the extent of the improvements made to facilitate the sale of it, the frequency and continuity of sales, and the time and effort expended by taxpayer in promoting the sales in relation to his other activities all must be factually presented as evidence to the Court in order to win against an IRS Capital Gain to Ordinary Income Audit. Second, after you purchase your land, feel free to outsource development to developers creating written extemporaneous documentation of your intent to sell property to those developers at some point in time but only after the land appreciates in value. Finally make sure the same tax attorney who represented you on both the buy and sell side of the transaction prepares and files your tax return claiming capital gain treatment of the sale. When the IRS Capital Gain to Ordinary Income Audit commences years later your tax attorney will easily be able to present the facts to the Court you will need to win the audit, keep intact your long term Capital Gain, and prevent the Government from taxing you at much higher ordinary income rates.
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Chris Moss CPA Tax Attorney