Question

Betty is a real estate dealer and has numerous properties for sale, many of which she owns. Her son is finishing his education and plans to go into the consulting business. Betty has committed at least $25,000 to help him out until the business becomes self-sufficient. Betty plans to dispose of one of the properties but wants to know if there is any way the gain on the property can be taxed at capital gains rates rather than as ordinary income.

Answer 1

Yes Betty's gain on the property can be taxed at capital gains rates rather than as ordinary income. Following paragraphs explain how. I've given an elaborate solution kindly go through it.

I.R.C.§1221(a) broadly defines the term “capital asset” as all property held by the taxpayer. Eight exceptions from that broad definition are provided. The first exception, I.R.C. §1221(a)(1), states that property that is either inventory or like inventory cannot qualify as a “capital asset.” In particular, I.R.C. §1221(a)(1) says a capital asset does not include “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” Whether a landowner is holding land primarily for sale to customers depends on the facts. As the U.S. Circuit Court of Appeals for the Tenth Circuit put in in the classic case of Mauldin v. Commissioner, 195 F.2d 714 (10th Cir. 1952), “There is no fixed formula or rule of thumb for determining whether property sold by the taxpayer was held by him primarily for sale to customers in the ordinary course of his trade or business. Each case must, in the last analysis, rest upon its own facts.” The Fifth Circuit has said essentially the same thing in Suburban Realty Co., v. United States, 615 F.2d 171 (5th Cir. 1980).

I.R.C. §1237 specifies that gain from the sale or exchange of up to five lots sold from a tract of land can be eligible for capital gain treatment. Sale or exchange of additional lots will result in some ordinary income. To qualify for the safe harbor, both the taxpayer and the property must meet the requirements of I.R.C. §1237 and make an election to have the safe harbor apply. For the taxpayer to qualify for the election, the taxpayer cannot be a C corporation. Presumably, an LLC taxed as a partnership would qualify. For property to qualify, it must have not previously been held by the taxpayer primarily for sale to customers in the ordinary course of business; in the year of sale, the taxpayer must not hold other real estate for sale as ordinary income property; no substantial improvement that considerably enhances the property value has been made to the property (see I.R.C. §1237(b(3); Treas. Reg. §1.1237-1(c)); and the taxpayer must have held the property for at least five years. I.R.C. §1237(a).

If the requirements are satisfied, the taxpayer can elect to have the safe harbor apply by submitting a plat of the subdivision, listing all of the improvements and providing an election statement with the return for the year in which the lots covered by the election were sold.