Volume 19 Issue 1 -- January/February 2007
many years the tax law has afforded special tax treatment for the sale of
certain assets held for more than a specified period of time, such as one year.
The theory is that it would be unfair to tax in one year when the asset
is sold, all of the gain that accumulated over a period of years at regular
income tax rates.
desire to mitigate the effect of taxation of gain accumulated over more than one
year led to a special tax structure called “Capital Gains,” under which
capital gains are taxed at lower rates than ordinary income. Currently for all
but those in the lowest ordinary income tax brackets the rate is 15%, in
contrast to ordinary income tax rates that are often in the range of 28% to 35%.
As with all tax rules, there are exceptions, such as the 28% rate for
collectibles and the 25% rate for the portion of gain attributable to
depreciation claimed on some real estate.
asset held for sale in the ordinary course of a business is considered inventory
and does not qualify for lower capital gains rates when sold.
Land held for sale by a real estate dealer, for example, is
“inventory” of the dealer and, when sold by the dealer, does not qualify for
the lower capital gains rates.
this “inventory” concept preclude a real estate dealer, such as Richard
Recordless, “Dick,” from obtaining capital gains rates on the sale of the
ITZMINE property he has held for 20 years?
answer for Dick depends on the circumstances and on his records (or the lack of
them) which in turn help answer the question of whether the land held for 20
years is part of Dick’s inventory of real estate. Did Dick treat the land as
part of his parcels of real estate for sale?
If ITZMINE was not part of Dick’s inventory of real estate held for
sale in the normal course of his real estate business how does he establish this
than be record-less, Dick needs to do most of the following things regarding
ITZMINE: (1) establish a separate bank account to pay all taxes and
expenses on the property; (2) rent or use the property in a manner
consistent with investment usage such as rent the property to others for sports
events, grazing cattle, raise Xmas trees, etc.; (3) report the income, if
any, from the property on a separate Schedule E as part of his 1040 tax return
or, even better, form an entity, such as an LLC, to hold or manage the property.
theme here is to treat ITZMINE in a manner different from other properties held
for sale in the ordinary course of Dick’s real estate business.
if Dick Recordless had inherited ITZMINE, a 300-acre farm near D.C. and decides
to subdivide it into lots and sell such lots.
Had Dick not subdivided the farm but sold it as a whole to one purchaser,
the gain could be capital gain. But, what’s wrong with subdividing?
Dick subdivides the farm and offers the lots for sale he is creating an
inventory of lots for sale in the regular course of that business. As a result,
Dick has created an inventory of lots and is deemed to be in the business of
selling them. Even if Dick had not
been in real estate sales before subdividing the farm and offering the lots for
sale, the gain would still be ordinary income to Dick in most situations.
1237 of the tax code creates an exception for the sales of small numbers of
subdivided lots, but there are a number of hurdles to obtaining the benefits of
capital gains rates. For example,
the person selling the lots must have owned the land for 5 or more years prior
to subdividing the property and have made no substantial improvements on the
property. While it is not possible to delve into this exception at length,
readers should be aware of it and analyze the situation and the law carefully
before relying on the exception.
key message is, if someone subdivides land, the income from the sale of lots may
be taxed at ordinary, as opposed to capital, gains rates.
if Melvin (not a realtor) inherits a farm and contributes it to a partnership in
which there is a realtor-partner? If
Melvin had sold the farm by himself he probably would have qualified for capital
gains treatment, but by contributing it to a partnership with realtor-partners
where the partnership engages in subdividing and selling lots, the partnership
has an inventory of lots and any gain that Melvin receives from the partnership
will be ordinary gain to him and the other partners.
those focusing on obtaining capital gains treatment on the sale of real estate
and other assets the question of “inventory” is critical, and there are many
fact situations and gray areas that cannot be addressed in this newsletter.
you have further questions call The Tax and Business Professionals for
By Tax and Business Professionals, Inc.
9837 Business Way
Manassas, VA 20110
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