Our tax laws are not perfect. There are grey areas. Most of these grey areas are of little consequence as they do not have a significant impact on the amount of tax that is due.
There are other grey areas that can significantly impact the amount of tax due. These tax disputes are frequently litigated.
One of these areas is whether an asset is a capital asset or an ordinary asset. This raises questions as to whether the capital or ordinary gain rates apply. It also raises questions as to the timing of deductions, as capital gains and losses may only offset other capital gains and losses.
This last point is particularly relevant now given the CARES Act and the ability for ordinary losses to generate net operating losses. These losses can be carried back five years to generate tax refunds by offsetting other ordinary income. This isn’t possible with capital gains.
Many of these disputes involve real estate or real estate-related activities. This brings us to the Keefe v. Commissioner, Nos. 18-2357-ag, 18-2594-ag (2nd Cir. 2020) case. The court considers whether rental real estate is a trade or business.
Facts & Procedural History
The taxpayer-husband had a full time job. The taxpayer-wife did not.
In 2000, they purchased a 14,400-square-foot historic waterfront mansion and property on Ocean Avenue in Newport for $1.35 million. They split the property and sold that portion for $950,000.
They continued to restore the remaining portion of the property. Taxpayer-wife oversaw the construction from 2002 through 2004. The taxpayers moved to Florida, but the taxpayer-wife continued to supervise the construction from Florida and by making trips to Newport.
In 2006, the taxpayers had a real estate agent inspect the property for possible rental.
The taxpayers obtained two temporary certificates of use and occupancy in 2007.
In 2007, the real estate agent began talking to clients about renting the property. There were no takers.
The renovations were completed in May of 2008 and the property was listed for sale. The property sold in 2009 for $6 million.
On their 2009 tax return, they reported the transaction as a sale of a capital asset. After talking to a tax planning attorney, they filed an amended return to report the transaction as the sale of an ordinary asset. The loss resulted in a net operating loss (NOL) that was carried to other years that also generated refund claims.
What is a Capital Asset?
Capital assets are stated in the negative. Section 1221 provides a list of what a capital asset does not include.
As relevant here, one item that is not a capital asset is “property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business.”
The first category considers depreciation. There are rules that say when depreciation starts. It is generally when the property is “in a condition or state of readiness and availability” for the “specifically assigned function.” We have considered these rules for depreciating yachts and depreciating airplanes in prior posts. We don’t have to go into these rules here as both the first and second categories impose a “trade or business” requirement.
Is Real Estate a Trade or Busienss
The term “trade or business” usually means something that requires the taxpayer to perform a service. It requires activities.
For real estate businesses, minimal services suggest that the activity is not a trade or business. More services suggest that there is a trade or business.
Those selling real estate, such as realtors, are likely to be a trade or business as they perform just services. Those developing more than one property may or may not have a trade or business. Those holding a single-family house for rental are less likely to have a trade or business.
The courts have created a factor analysis for deciding whether real estate is used in a trade or business. The second circuit courts consider these factors:
- the taxpayer’s efforts to rent the property;
- the maintenance and repairs supplied by the taxpayer or an agent of the taxpayer;
- the taxpayer’s employment of labor to manage the property or provide services to tenants;
- the purchase of materials; the collection of rent; and
- the payment of expenses.
The appeals court considered these factors in this case.
Rental Real Estate as a Trade or Business
According to the court, the property was a capital asset. It was not used in a trade or business.
In applying the factors above, the court did not find any factors in the taxpayer’s favor. It noted that:
- The property was listed for sale from 2004-2009.
- The property was never rented.
- The property was never held for rental (the rental agent visited the property a year before it was ready to even be a rental).
- The taxpayers took a state historic rehab credit that did not require the property to be a rental, but failed to take the corresponding Federal credit that had the requirement.
- The taxpayers did not obtain a permit to be a short term rental or notify the adjoining property of the rental as required by the governing documents.
The court also considered the taxpayer’s argument that other court cases show that the taxpayers may have failed in their goal but should still be treated as a trade or business. The court found the cases to be distinguishable from the present case:
In the cited cases, the taxpayers were already conducting a trade or business sufficient to support a finding that the asset in question was held for use in that trade or business, despite that the asset had not yet been used itself. Under the circumstances in each of those cases, the tax court concluded that the taxpayer held the asset for use in a trade or business: a major shareholder of an office supply and equipment corporation who incurred a loss from the sale of a building that had never been rented, a radio broadcaster who incurred a loss from the sale of a never-used radio transmitter, and a tobacco company that incurred a loss from the sale of real property before ever implementing the property’s planned use.
This suggests that if the taxpayers had owned one or more rental properties in the past, they may have already been in the rental business and that history would allow this activity to be a trade or business.
This case shows the importance of planning for taxable transactions in advance. Had the taxpayers done so, they might have taken additional steps to show that the activity was, in fact, a business. This might include aggressively listing the property for rental, setting up a website to rent the property, obtaining a landlord type insurance policy, etc.
They might also have purchased one or more rental properties. Even if it was just a few inexpensive properties in the mid-west, they may have been able to show that they were in the rental business. The tax savings from this property may have been large enough to justify buying a few less expensive properties.