A recent Tax Court case addressed a situation we have seen on several occasions. In Rice v. Commissioner (June 16, 2009), the taxpayers bought 14.4 acres of property in Austin, Texas to build their “dream home.” While they initially intended to retain the entire parcel, the wife later decided she would feel too isolated living on such a large property. They subdivided the parcel into 10 smaller lots and built their home on one of them. They sold one of the excess lots to friends in 2000. In 2002, they placed a wooden sign at the entrance to their subdivision advertising lots for sale. This was the only advertising they did and their subsequent sales were mostly through word of mouth. In 2004, they sold three more lots to friends and to the wife’s sister and her husband. By 2008, they had sold the remaining lots to friends and acquaintances, after reserving one lot for their daughter. The taxpayers claimed capital gain treatment for all of these sales.
The IRS claimed that the lots sold in 2004 gave rise to ordinary income because the sales were made in the ordinary course of the taxpayers’ trade or business. The Tax Court held in favor of the taxpayers that they were entitled to report their gain as capital gain. Several factors went into the court’s reasoning: i) they originally intended to use the entire property for their own residence; it was not purchased with a view to subdividing it; ii) between 2000 and 2008, they sold on average only one lot per year; iii) they engaged in only very limited advertising and marketing activities; and iv) they both had full time jobs and devoted little time to the sale of the excess lots.
If you are in this situation, you obviously will enhance your chances of obtaining capital gain treatment if you can minimize the marketing and advertising that you do to sell the excess lots. Sales by word of mouth to friends or acquaintances are clearly preferable. Stretching the sales out over multiple tax years will also be helpful.