Claiming an Ordinary Loss on the Sale of Real Estate
Clients often ask whether real estate losses, recognized via sale or other disposition, can be treated as ordinary deductions rather than capital losses. Generally speaking, ordinary losses are preferred to capital losses because such losses are eligible to be offset against a broader range of income sources, such as salaries and wages and the distributive share of operating income from partnerships and S-Corporations.
In order to justify ordinary loss treatment on the sale or other disposition of real estate, taxpayers may allege that they are in the business of real estate, asserting that their real estate properties were held for sale as inventory. In Musselwhite vs. Commissioner, such a position proved difficult to defend.
Mr. Musselwhite was a personal injury lawyer in Lumberton, North Carolina. Over the years, Mr. Musselwhite participated in various real estate ventures in North Carolina. In June 2005, Mr. Musselwhite and Mr. Stephenson, a local businessman with an existing real estate development company, formed a new limited liability company, DS & EM Investments, LLC, in North Carolina. Annual reports that were filed between 2006 – 2012 described the nature of the business as “real estate investment.”
In the summer of 2006, DS & EM Investments, LLC entered into a real estate agreement with Mr. Lisk, a local real estate developer, to acquire four undeveloped wooded lots. It was expected that Mr. Lisk would develop the parcels and market them for sale. Due to a downturn in the economy, Mr. Lisk informed DS & EM Investments, LLC that he would be no longer able to develop the four lots, as was originally agreed to. In a later legal settlement, Mr. Lisk agreed to complete the remaining property improvements and transfer additional lots to DS & EM Investments, LLC as payment for his failure to perform. The improvements and settlement transfers occurred in December 2008. DS & EM Investments, LLC performed intermittent maintenance on the four lots afterwards.
The four lots held by DS & EM Investments, LLC were encumbered by debt. From 2009 to 2012, the mortgagee had three, separate appraisals performed on the four lots, each which returned a lower valuation than the previous one. The appraisal reports did not show a history of lot sales or market listings.
In July 2012, Mr. Musselwhite and Mr. Stephenson distributed the properties held by DS & EM Investments, LLC and personally assumed the outstanding debt. As part of the distributions, Mr. Musselwhite received the four lots. In August 2012, Mr. Musselwhite hired a real estate broker to market the four lots for sale. In November 2012, Mr. Musselwhite sold the four lots at a loss of approximately $1 million. On Mr. Musselwhite’s 2012 IRS Form 1040, Schedule C, Mr. Musselwhite reported the $1 million loss on the disposition of the four lots as an ordinary loss deduction. Upon reviewing Mr. Musselwhite’s tax filings, the IRS recharacterized the reported loss as a capital loss and assessed additional taxes to the taxpayer.
The objective of the Tax Court’s inquiry was to “differentiate between the ‘profits and losses arising from the everyday operation of a business’ on the one hand . . . and ‘the realization of appreciation in value accrued over a substantial period of time’ on the other hand.” There was no evidence that Mr. Musselwhite was involved in the continuous real estate sales as a sole proprietor. To state it differently, Mr. Musselwhite was a personal injury lawyer, and not a real estate developer.
The conversion of real estate from investment property to inventory can be quite challenging and requires long-term tax planning. Here are some recommendations for those considering such a conversion:
1. Report the real property as inventory for at least two tax years. Make sure that the primary business activity listed on the tax filings are for real estate development, and not real estate investment.
2. Be able to prove a track record of sales or listings over multiple years. Use a real estate agent / broker.
3. Perform activities common to a real estate developer, including but not limited to, improvements and routine repairs and maintenance.
Thank you to our amazing National Tax Office for assisting me with this blog post.
- Carey M. Heyman, CPA
- Managing Principal of Industry - Real Estate
- CliftonLarsonAllen LLP
- Century City (Los Angeles)
Carey is the Managing Principal of the Real Estate Industry at CLA. He is a trusted advisor with close to 20 years of experience providing accounting, assurance, tax, and consulting services to real estate industry owners, operators, family offices, developers and syndicators. Carey has a strong track record of helping clients build and retain capital by leveraging tax- and cost-saving strategies and employing tax credits and incentives. He also consults with high net worth individuals, large family groups, and owners of closely-held businesses on all aspects of tax planning, estate planning, and retirement planning.
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