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

Freeman Law's " The Tax Court in Brief" covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

For a link to our podcast covering the Tax Court in Brief, download  here or check out other episodes of  The Freeman Law Project.

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


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.