Bennett v. Commissioner, T.C. Memo 2012-193 (July 12, 2012), also involved a personal residence. The taxpayers bought a residential property in the Bel-Air section of Los Angeles with the intent of constructing a residence they hoped to sell at a profit. After five years, the taxpayers had not completed the residence and sold it, at a loss, in its uncompleted state, to avoid further losses. On their 2002 income tax return, the taxpayers deducted an ordinary loss from the sale of the residence.

The IRS first disallowed the loss altogether, taking the position that the taxpayers intended to occupy the property as their residence, making it a personal-use asset, the loss on which is not deductible. The Tax Court held in favor of the taxpayers on this issue, finding that they had adequately demonstrated that they did not intend to occupy the property themselves. The IRS next argued that the loss, if allowed, should be treated as a capital loss. The taxpayers’ position was that they were engaged in a trade or business of developing and selling property, and therefore this property was excluded from capital asset status under IRC Section 1221(a)(1). The IRS took the position that the taxpayers did not have a sufficient level of activity to be considered engaged in a trade or business. The Tax Court agreed with the IRS and determined that the taxpayers had sustained a capital loss. The court distinguished earlier cases involving the construction and sale of a single property, finding that, in all of the prior cases in which the construction and sale of a single property had been found to constitute a trade or business, the taxpayer had a pre-existing contract to sell the house before constructing it. That was not the case here.

One question this case raises is what would the IRS have done if the taxpayers had sold the house at a gain and reported the gain as a capital gain? Would the IRS then have argued that they were engaged in a trade or business? Future taxpayers who do have gains will no doubt cite this case as further precedent that the development of a single property yields capital gain as long as they have no pre-existing contract to sell the property before constructing it.