Is the sale of real property ordinary income or capital gain?

• Author: Koppel, Michael D.

The question of whether a sale of real property produces capital gain or ordinary income is a matter of tax law interpretation. The taxpayer's intentions and actions in each situation need to be examined to determine if the taxpayer is in the business of selling real property to customers, which would cause the transactions to be subject to ordinary income taxes as opposed to the more favorable capital gains rates.

The recent case of Flood, T.C. Memo. 2012-243, illustrates this issue. There are other issues in this case, but this item focuses on the classification of income from the sale of real property.

The facts of the case are straightforward. During the time in question, Donald Flood was a day trader in the stock market. He and his wife also were active in real estate activities that consisted of purchasing and reselling vacant lots. In general, the Floods did not make any improvements to the land they purchased. Between 2001 and 2008, the Floods purchased approximately 250 lots. They sold 2 lots in 2004 and 40 lots in 2005. In 2005, they donated 11 lots to the Sawyer Road Baptist Church. In 2004 and 2005, the Floods had profits, which they reported on Schedule D as capital gain. The IRS reclassified the gain as business income that should have been reported on Schedule C and taxed at ordinary income rates. The IRS also determined that the Floods were subject to self-employment tax on the income.

In determining whether the income should be classified as ordinary income or capital gain, the court evaluated nine criteria: (1) the taxpayer's purpose in acquiring the property; (2) the purpose for which the property was subsequently held; (3) the taxpayer's everyday business and the relationship of the income from the property to the taxpayer's total income; (4) the frequency, continuity, and substantiality of sales of property; (5) the extent of developing and improving the property to increase sales revenue; (6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales; (7) the use of a business office for the sale of property; (8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property; and (9) the time and effort the taxpayer habitually devoted to sales of property. It is important to note that, under Sec. 1221(a)(1), property is not a capital asset if it...