Mansion Was Capital Asset, Not Section 1231 Property, Despite Substantial Renovations

(Parker Tax Publishing July 2020)

The Second Circuit affirmed a Tax Court judgment that a couple held an historic mansion as a capital asset, rather than as real property used in a trade or business, and was therefore not entitled to take an ordinary loss on the sale of the property. The Second Circuit found that the couple did not engage in regular and continuous activity in relation to the property as required for use in a trade or business under Code Sec. 1231, did not meaningfully begin any rental activity, did not take the steps required to rent the property, and were not already engaged in any kind of trade or business when they bought the property. Keefe v. Comm'r, 2020 PTC 214 (2d Cir. 2020).

Background

In January 2000, David and Candace Keefe purchased a 14,400-square-foot historic waterfront mansion and property in Newport, Rhode Island for $1.35 million, with the intent of restoring it. They did not live on the property. The couple financed the purchase through a series of loans, including one from Bank of America. In 2002, the Keefes executed a declaration of condominium dividing the property in two: Wrentham House and Carriage House. They sold Carriage House for $950,000 and kept Wrentham House. The declaration of condominium required that, in order to rent out Wrentham House, the Keefes had to notify the owners of Carriage House and register Wrentham House with the Newport city clerk as either a short-term rental or a guest house.

Wrentham House was uninhabitable when the Keefes purchased it. The Keefes initially estimated that the restoration would cost $2 million, which they financed through loans. Due to unexpected delays, the Keefes had to secure additional loans to cover increased costs. The construction began in late 2002 and was completed in May 2008. During that time, the Keefes contracted with a real estate agent to list the house for sale. The house was listed continuously from May 2004 through its ultimate sale in July 2009, except for one week in 2008.

From the beginning of construction in 2002 through 2004, Mrs. Keefe regularly visited Wrentham House to oversee the restoration. In 2005, the family moved to Florida, but Mrs. Keefe frequently traveled to Newport to continue to oversee the construction and closely managed the progress by phone when she was not there. According to the Keefes, Mrs. Keefe spent 60 to 70 hours per week overseeing the renovation.

In 2006, the Keefes met with Laurie Hewitt Burke, a rental agent, to discuss renting Wrentham House. In 2007, Burke began speaking to clients about renting the house. She did not advertise online because she did not believe she could market the house while the renovations were ongoing. Only one client expressed an interest in renting, but he did not enter into any rental agreement or pay a security deposit. After the restoration was finally completed in May 2008, the house was no longer held out for rent, and ultimately it was never rented. At no point did the Keefes notify the owners of Carriage House of any rental plans or register the house with the Newport city clerk as required by the declaration of condominium in the event of a Wrentham House rental.

In 2008, Bank of America increased the Keefes' monthly mortgage payment from $25,000 to $39,000. The Keefes had taken out a second mortgage, which was conditioned on their continued efforts to sell the property. The Keefes made various efforts to sell the property, including contacting three auctioneers, although no auction ever took place. Finally, in July 2009, the property sold for $6.51 million.

On their 2009 tax return, the Keefes reported the sale of Wrentham House as the sale of a business property under Code Sec. 1231, rather than as the sale of a capital asset. They reported an ordinary loss on the sale, rather than a capital loss. The IRS determined that the sale should have been reported as a capital loss and determined deficiencies and accuracy related penalties. The Keefes took their case to the Tax Court, but the Tax Court ruled in the IRS's favor. The Keefes appealed to the Second Circuit.

Code Sec. 1221(a) defines a capital asset as "property held by the taxpayer (whether or not connected with his trade or business)." Under Code Sec. 1221(a)(2), an exception to the definition of a capital asset is provided for real property that is used in a trade or business of the taxpayer and, under Code Sec. 1231, losses on the sale of such property are eligible for ordinary loss treatment. Reg. Sec. 1.1221-1(b) clarifies that property held for the production of income, but not used in the taxpayer's trade or business, is not excluded from the term "capital asset." Under Second Circuit case law, renting out real property is considered a trade or business if the taxpayer engages in "regular and continuous" activity in relation to renting the property. Several factors are relevant in making this determination, including: whether the taxpayer (or an agent) performs maintenance and repairs, whether the taxpayer employs labor to manage the property or provide tenant services, and whether the taxpayer purchases materials, collects rent, and pays expenses.

The Keefes argued that, although they never rented Wrentham House, they began their rental activity by undertaking years of work and millions of dollars of renovation costs in order to make the property suitable for rental. In support of their argument, the Keefes cited Tax Court cases, including Alamo Broadcasting Company, Inc. v. Comm'r, 15 T.C. 534 (1950), in which taxpayers failed to carry out a business goal and yet were held to be engaged in a trade or business. Based on these cases, the Keefes asserted that a failure to use the asset as intended does not necessarily preclude a determination that it was used in a trade or business.

Second Circuit's Analysis

The Second Circuit affirmed the Tax Court's decision after finding that the Keefes did not engage in regular and continuous rental activities because they never began rental activity in a meaningful or substantive way. The court noted that the Keefes did not advertise Wrentham House online, sign a lease with any potential tenant, furnish the property for rent after it was ready to occupy, comply with the notice and registration steps required by the declaration of condominium to rent the property, or receive any rental payments or security deposits.

The court acknowledged that the Keefes did take some limited steps toward renting the property by engaging a rental agent. However, these rental efforts occurred only before the house was ready to occupy and the house was not held out for rent at any time after the restoration was complete. In the court's view, the Keefes' insignificant efforts to rent Wrentham House stood in contrast to their significant efforts to sell it. The court found that the Keefes listed the house for sale almost continuously from 2004 to its ultimate sale in 2009, had it appraised in 2005, and adjusted the list price at least five times. These facts suggested that the Keefes were making real efforts to sell the property rather than creating a nominal listing simply because it was required in order to take out a second mortgage. The court found that the Keefes' restoration efforts, including Mrs. Keefe's work overseeing it, no more evinced intent to improve the property with the goal of renting it than with the goal of selling it, especially given the Keefes' lack of other meaningful steps to begin rental activity.

The court found that the Tax Court cases cited by the Keefes were distinguishable because, in those cases, the taxpayers were already conducting a trade or business sufficient to support a finding that the asset in question was held for use in that trade or business, despite that the asset had not yet been used itself. The court said that in contrast, there was no evidence that the Keefes were already engaged in any sort of rental trade or business before purchasing and renovating Wrentham House. The court noted that the Keefes had never previously tried to rent any other property, and the court found that they did not meaningfully begin efforts to rent Wrentham House.

The court also upheld the imposition of accuracy-related penalties. The court found that the Keefes provided no evidence to support a finding that they adequately disclosed the relevant facts affecting the tax treatment of the item in question or that they had a reasonable basis for the claimed treatment. The court further found that the Keefes did not have substantial authority for their position because the cases they cited were factually distinguishable. In addition, the Keefes did not attempt a showing of good faith or reasonable cause before the Tax Court or on appeal.

For a discussion of the definition of a capital asset, see Parker Tax ¶111,105. For a discussion of the rules for dispositions of Code Sec. 1231 property, see Parker Tax ¶112,105. For a discussion of accuracy related penalties, see Parker Tax ¶262,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com