Editor: Carolyn Quill, CPA, J.D., LL.M.

Co-editors: Richard Mather, E.A., MSA, CAA; Jonathan McGuire, CPA; and Kathleen Moran, CPA, MBA, MT

It is the age-old struggle of taxpayers in the business of developing and owning real estate — how to turn a profit from the sale of real estate into a capital gain but, if there is a loss, how to deduct it as an ordinary loss. Musselwhite, T.C. Memo. 2022-57, is not the first Tax Court case in which the taxpayer argued with the IRS over whether the real estate was an investment versus held in the ordinary course of a trade or business. However, two things stand out about this case — the first is that it was an ordinary loss recast into a capital loss. The second is that the history of tax returns and reporting seemed to be as crucial in the court’s analysis and fact-finding as the taxpayer’s lack of real estate development activity.

Ultimately, the sole dispute in this case was whether the land was a capital asset or inventory. Capital assets are property held by the taxpayer, except for certain items such as stock in trade of the taxpayer held primarily for sale to customers, or depreciable property used in a trade or business (Sec. 1221(a)). Further, the Supreme Court has held that the purpose of Sec. 1221(a) is 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” (Malat v. Riddell, 383 U.S. 569, 572 (1966)).

Because the case involves whether the taxpayer was a real estate dealer or merely an investor, it is necessary to discuss some details about his activities. Since 1981, the taxpayer, William Musselwhite, had been a practicing personal injury attorney at his family’s law firm in North Carolina. In 1986, the taxpayer joined his father, uncle, and brother in his first real estate venture — a 100-acre residential land development and eventual sale of 90 lots over 13 years. Also during this time, the taxpayer and his brother were involved in a similar 100-acre phased development, likewise in North Carolina.

In 2005, Musselwhite met a future business partner who was a real estate developer. Together they formed a two-member limited liability company (LLC). On the first and subsequent North Carolina LLC annual reports, the LLC indicated the nature of its business was real estate investment. The LLC initially purchased for investment purposes five condominiums and immediately sold two. In addition, it purchased two undeveloped lots and a house in Wilmington, N.C. In 2006, a third-party developer approached the LLC and its members, including Musselwhite, with a deal to purchase their Wilmington house for $1 million, and the LLC would, in turn, purchase four wooded lots from the third party’s development. This third party also offered a one-year personal guaranty that the lots would sell within one year and net $1 million or he would buy back the remaining unsold lots.

A year later, as the real estate market started to take an ugly turn, the lots had not sold, and, in 2008, the LLC sued the third party to enforce his promise to repurchase the lots. Instead, the third party agreed to complete any remaining improvements and transfer his five lots to the LLC in exchange for dismissing the lawsuit.

From 2008 to 2011, the LLC continued to own the condo and the original four lots but made no further improvements to the properties. Until 2011, the LLC listed no inventory on Schedule L, Balance Sheets per Books, of its Form 1065, U.S. Return of Partnership Income, and listed the original four lots as “Investment — Real Estate.” However, on the 2011 and 2102 returns, the lots were reported on the LLC’s Schedule L of Form 1065 as “inventories.”

In June 2012, the lienholder of the deed of trust covering the four lots appraised the four original lots at $17,500 and began to pressure the LLC about them. To alleviate personal debt exposure, Musselwhite and his business partner agreed to divide up their jointly owned properties, including those held by the LLC. As part of this deal, Musselwhite took a distribution from the LLC of the condo and the four lots. In 2012, Musselwhite was able to sell the condo and the lots, generating losses of approximately $137,780 and $1,022,726, respectively.

On his return for 2012, Musselwhite treated the loss from the four lots as ordinary losses by reporting their sale on Schedule C, Profit or Loss From Business, with the title “Activities Related to Real Estate.” This allowed him to offset the loss against the considerable income he received from his law practice. He included the loss from the sale of the condo as a capital loss on Schedule D, Capital Gains and Losses. The IRS objected, finding that the loss from the sale of the four lots was a capital loss he could not offset against his legal practice income. The IRS issued Musselwhite a notice of deficiency, and he subsequently challenged the IRS’s determination in Tax Court.

The sole dispute before the Tax Court concerned the character of Musselwhite’s reported $1,022,726 loss arising from his sale of the four lots. In its analysis, the court considered the reporting positions taken by the LLC on its prior-year returns with respect to the four lots and the factors identified by the Fourth Circuit, to which the appeal of Musselwhite’s case would lie, as relevant to a determination of whether property is inventory.

In the court’s analysis of this issue, the history of the LLC’s tax returns and reporting was considered significant, as noted above. On the entity’s 2005 and subsequent filings of North Carolina LLC annual reports, the principal business activity of the LLC was listed as real estate investment. Further, on its Form 1065 for the 2005 through 2012 tax years, the entity reported its principal business activity as real estate investment. The tax returns never showed gross sales (which would generally indicate that the assets were held primarily for sale). Instead, when the LLC had sales during those years, they were reflected on Schedule D. The tax return balance sheet (Schedule L) listed the condos and lots as investments for 2005–2010. It was not until 2011 that the lots first appeared as inventory on the balance sheet.

As the determination of whether an asset is capital in nature relies on the facts and circumstances, the court also analyzed the facts of the case using the eight factors identified as relevant by the Fourth Circuit:

1. The purpose for which the property was acquired;

2. The purpose for which the property was held;

3. Improvements, and their extent, made to the property by the taxpayer;

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 or lack thereof; and

8. The listing of the property for sale directly or through a broker.

The courts have previously ruled that no one factor or group of factors is determinative, and not all factors may be relevant in a particular case — or factors may have varying degrees of relevance depending on the facts of a particular case (S&H, Inc., 78 T.C. 234 (1982)). Additionally, objective factors carry more weight than the taxpayer’s subjective statements of intent (see Guardian Indus. Corp., 97 T.C. 308 (1991), aff ’d without published opinion, 21 F.3d 427 (6th Cir. 1994)).

The taxpayer here failed all the factors except for factors 7 and 8 regarding the advertising and listing of the property for sale by a broker. The factors outlined below overwhelmingly, in aggregate, weighed against the taxpayer’s position that he should be able to take an ordinary rather than capital loss.

Factors 1 and 2. The purpose for which the property was initially acquired and subsequently held: The first two factors did not support the taxpayer’s position that the four lots were inventory, the court held. He lacked real estate development activity, the properties were classified on the balance sheet as an investment, and the sales of all previously owned properties were reported on Schedule D of the tax returns.

Factor 3. The extent of improvements to the property: This factor also weighed against the taxpayer’s position that the four lots were inventory. The last real estate development activity was performed by the third party at the end of 2008. Once the property was acquired, the only activities that occurred were annual maintenance and preparing it for sale. Therefore, the extent of improvements made to the property after the LLC took possession of it was negligible.

Factor 4. The frequency, number, and continuity of sales: As outlined above, the LLC never reported any gross sales or receipts. When there were sales of property, the LLC reported them on Schedule D. Since the focus here was on the taxpayer’s activity, the only evidence the court had was of investment. The lack of reported sales elsewhere indicated this was an isolated transaction. The court held that factor 4 weighed against the taxpayer because of a lack of frequency, number, and continuity of sales.

Factor 5. The extent and substantiality of the transaction: The taxpayer’s sale of the four lots was the only sale associated with this transaction. The record before the court was silent as to any continued involvement by him in lot development after he sold them. The court viewed the change in the balance sheet’s classification to inventory in 2011 as the taxpayer’s “purported ‘ticket’ to getting a significant ordinary loss through a quick sale of the lots.” The court held that factor 5 weighed against the taxpayer.

Factor 6. The nature and extent of the taxpayer’s business: Musselwhite’s everyday business was not the development and sale of real estate, as he was a personal injury attorney, receiving taxable income in excess of $700,000 for each of the years from 2011 to 2013. The wages or allocable income he received indicated that his activities as an attorney were full-time endeavors. The court held that factor 6 weighed against the taxpayer.

Factors 7 and 8. Extent of advertising and sale of property through the use of a broker: These were the only factors that favored the taxpayer. He hired a broker immediately upon distribution of the assets from the LLC. The broker indicated in a letter that she put a substantial amount of time and effort into marketing the lots.

Overwhelmingly, then, the eight factors weighed against Musselwhite’s position that he should be able to take an ordinary loss. The Tax Court upheld the IRS’s determination that his $1,022,726 loss from the sale of the four lots was a capital loss.