Tax Courtroom In Transient | Musselwhite v. Commissioner | Loss In Sale Of Actual Property: Extraordinary Loss Or Capital Loss? – Earnings Tax

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The Tax Court in Brief – June 6th – June 10th,
2022

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Tax Litigation:  The Week of June 6th, 2022, through
June 10th, 2022

Musselwhite v. Commissioner,  T.C.
Memo. 2022-57 | June 8, 2022 | Ashford, J.| Dkt. No.
14380-16

Opinion

Summary: William Musselwhite was involved
in real estate ventures since about 1986. In 2005, Musselwhite and
his business partner formed DS & EM Investments, LLC
(DS&EM). In 2006, DS&EM purchased 4 unimproved lots for $1
million from Adam Lisk. DS&EM re-platted the 4 lots into 9. The
terms of agreement with Lisk included certain
guarantees-of-resale-within-one-year, allocation of ownership of
the 9 lots (4 with DS&EM and 5 with Lisk), buy-back provisions,
and other conditions relating to the development and sale of the
lots, including that Lisk would complete improvements on some of
them. DS&EM financed the purchase price with a loan from
BB&T Bank. In 2007, the real estate market crashed, and due to
incomplete improvements and lack of sales per the deal, DS&EM
sued Lisk. In 2008, and in order to resolve the lawsuit, Lisk
transferred his 5 lots (now partially improved) to DS&EM.
Thereafter, no improvements were made to those 5 lots and the
development activities all but ceased. BB&T subsequent
appraisals of the lots indicated that the property was not known to
be for sale. Due to the depressed real estate market, DS&EM and
its two members (Musselwhite and his business partner) divided up
their various properties and debts, and DS&EM distributed the
4-of-9 lots to Musselwhite. Within 4 months of receiving the 4
lots, Musselwhite sold them for $17,500, realizing a loss of
$1,022,726. On Musselwhite’s 2012 Form 1040, he (and his wife
filing jointly) reported a Schedule
C business loss deduction loss of $1,022,726 relating to
the sale of the 4 lots which Musselwhite reported as cost of goods
sold. Following an exam of Musselwhite’s 2012 Form 1040, the
IRS determined that Musselwhite was not entitled to the reported
$1,022,726 Schedule C loss because the 4 lots were capital assets
and thus their sale generated a capital (and not ordinary) loss. A
notice of deficiency was issued, and the matter was petitioned to
the Tax Court for review.

Key Issues:

  • The sole issue is whether the $1,022,726 loss should be
    characterized as an ordinary loss or as a capital loss. The issue
    hinges on whether the lots were, pursuant to 
    26 U.S.C. § 1221(a)(1), “stock in trade of the
    taxpayer or other property of a kind which would properly be
    included in the inventory of the taxpayer if on hand at the close
    of the taxable year, or property held by the taxpayer
    primarily for
     sale to customers in the ordinary
    course of his trade or business.” If they were, then their
    sale resulted in an ordinary loss and not a capital loss.

Primary Holdings:

  • The Tax Court found that the lots were capital and not stock in
    trade as defined in section 1221(a)(1). The relevant factors for
    evaluating a dispute arising from section 1221(a)(1) overwhelmingly
    weighed against Musselwhite. Deficiency upheld.

Key Points of Law:

  • Section 1221(a)(1).  The purpose
    of 
    section 1221(a)(1)—Capital asset defined—is to
    differentiate between (1) the profits and losses arising from the
    operation of a business and (2) the realization of appreciation in
    value accrued over a substantial period of time. Malat v.
    Riddell, 383 U.S. 569, 572 (1966). The term
    “primarily” as used in section 1221(a)(1) means “of
    first importance” or “principally.” Whether property
    is property described in section 1221(a)(1) is a question of fact,
    and the burden of proof is on the taxpayer to demonstrate that the
    property in question is as described in section 1221(a)(1) (and not
    as a capital asset). See Pasqualini v. Commissioner,
    103 T.C. 1, 6 (1994); Maddux Constr. Co. v.
    Commissioner, 54 T.C. 1278, 1284 (1970); see
    also Rule 142(a).
  • Factors to Determine a Section 1221(a)(1)
    Dispute. 
    Within the Fourth Circuit Court of Appeals,
    the factors applied to resolve such disputes include the following:
    (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. Graves v. Commissioner, 867 F.2d
    199, 202 (4th Cir. 1989). No one factor or group of factors is
    determinative, and not all may be applicable. ; S&H,
    Inc. v. Commissioner, 78 T.C. 234, 243–44 (1982). But,
    objective factors carry more weight than the taxpayer’s
    subjective statements of intent. See Guardian Indus. Corp.
    v. Commissioner, 97 T.C. 308, 316 (1991), aff’d
    without published opinion, 21 F.3d 427 (6th Cir. 1994).
  • Tax Treatment Applicable to Real Estate May
    Change. 
    A taxpayer may hold real estate primarily
    for sale to customers in the ordinary course of the taxpayer’s
    trade or business and, at the same time, hold other real estate for
    investment, but said taxpayer can cease holding real estate
    primarily for sale to customers in the ordinary course of its
    business and begin to hold it only for investment
    purposes. See Gardner v. Commissioner, T.C. Memo.
    2011-137, slip op. at 8; Sugar Land Ranch Dev., LLC v.
    Commissioner, T.C. Memo. 2018-21, at *10–11. Development
    activities may convert property originally acquired for investment
    into property held for sale to customers in the ordinary course of
    business. See Bush v. Commissioner, T.C. Memo.
    1977-75, aff’d, 610 F.2d 426
    (6th 1979).
  • Section 735 Inventory. 
    26 U.S.C. § 735(a)(2) provides that “(g)ain or loss
    on the sale or exchange by a distributive partner of inventory
    items (as defined in section 751(d)) distributed by a partnership
    shall, if sold or exchanged within 5 years from the date of the
    distribution, be considered as ordinary income or as ordinary loss,
    as the case may be.” Under section 751(d), inventory items are
    defined by reference to section 1221(a)(1). See 
    26 U.S.C. §§ 735(a)-(c), 751(d).

Insights:  Real estate may constitute
inventory, rather than a capital asset, for federal tax gain and
loss purposes. Section 1221(a)(1) of the Code is the applicable
statute for evaluating tax treatment of such gain or loss. To
constitute a stock in trade of the taxpayer, the taxpayer must hold
the real estate primarily for sale to customers in the ordinary
course of the taxpayer’s trade or business. A taxpayer may hold
real estate primarily for sale to customers in the ordinary course
of the taxpayer’s trade or business and, at the same time, hold
other real estate for investment. And, a property once held as
inventory for sale to customers may change in character for federal
income tax purposes, depending on the application of factors
developed and used by the Tax Court.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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