No Capital Gain Treatment for Properties Purchased at Tax Auctions for Quick Resale.

(Parker Tax Publishing February 15, 2015)

The Tax Court found that because taxpayers purchased a high volume of properties from county tax auctions and frequently resold the properties for quick profits, the could not treat the properties as capital assets and should have reported their profits as ordinary income. SI Boo, LLC, et al. v. Comm'r, T.C. Memo. 2015-19.

Background

S. I. Securities, Sabre, and SI Boo ("taxpayers") were organized in Illinois as limited liability companies and were treated as partnerships. S. I. Securities and Sabre participated in tax lien auctions throughout Illinois, purchasing judgment liens in the hopes of turning a profit.

In Illinois, county tax collectors may offer to sell certificates of tax liens at public auctions after the county has won judgments for nonpayment of taxes and the lien purchaser pays the county the delinquent taxes owed on the property. The owner of the property may redeem the encumbered property within a certain redemption period by paying the certificate amount, an accrued penalty, and certain other costs. If the period expires and the property has not been redeemed, then the owner of the tax lien certificate may petition for a tax deed with respect to that property, providing the owner of the certificate with merchantable title to the property.

Between 2007 and 2008, the taxpayers' acquisition of tax lien certificates from these auctions totaled approximately 6,500 certificates. To fund the purchases of the certificates, the entities drew against lines of credit established with several banks. Because interest accrued on the lines of credit, the taxpayers' hoped to make a profit on the spread between the interest rates charged against their lines of credit and the penalty rates they received if and when the certificates were redeemed.

If the certificates were not redeemed, the taxpayers' planned to sell the properties to third parties by quitclaim deed or contract for deed. In attempting to sell these properties, the taxpayers' intent was not to hold onto them for appreciation in value but rather to sell the properties quickly to recover their investment costs or to make a profit. During 2007 and 2008, the taxpayers' collectively sold 259 parcels of property by either quitclaim deed or by contract for deed and reported income they received from the sales as capital gains.

In 2010, the IRS issued final partnership administrative adjustments (FPAAs), in which it determined that because the entities held the properties acquired by tax deeds primarily for sale, rather than for investment, the proceeds should be classified as ordinary income. The tax matters partners for the three entities filed petitions with the Tax Court for readjustment of the partnership items.

Analysis

Capital assets do not include property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business (Code Sec. 1221(a)(1)). Whether property is held primarily for sale to customers in the ordinary course of a taxpayer's trade or business is a question of fact which must be determined by consideration of all the surrounding circumstances. (Guardian Indus. Corp. & Subs. v. Comm'r, 97 T.C. 308 (1991)). Courts consider numerous factors to determine the purpose for which property is primarily held and generally look to the taxpayer's purpose at the time the property is sold.

The Tax Court considered two factors to be particularly relevant to this case: (1) the frequency and regularity of sales of real properties; and (2) the substantiality of the sales and the relative amounts of income taxpayers derived from their regular business and the sales of real properties.

The taxpayers contended that the sales were not frequent in comparison to the number of certificates of purchase of tax lien they acquired. However, the court disagreed, noting that the taxpayers' accounting records, as well as the testimony presented at trial, showed that they intended to dispose of the properties quickly and frequently and with the intent to make a profit, and were successful in doing so. The court also pointed out that the taxpayers' effectively conceded in their written submissions to the court that most of the properties sold by quitclaim deed were sold within one year of their acquisition. Because of this, the court gave little weight to the fact that the taxpayers acquired more certificates of purchase of tax lien than tax deeds.

The court also noted that the taxpayers' sales of real properties were substantial, especially when viewed with respect to the total amounts of income each entity earned. The court pointed out that, as a general matter, frequent, regular, and substantial sales of real property are indicative of sales being made in the ordinary course of a trade or business, whereas infrequent sales of these properties are more indicative of real property held for investment purposes.

After applying the factors it considered relevant, the court concluded that the properties that the taxpayers acquired from certificates of purchase of tax lien and converted into tax deeds were properties held by the taxpayers primarily for sale to customers in the ordinary course of their trades or businesses, precluding characterization of those assets as capital.

The court additionally concluded that the taxpayers improperly reported their earnings by excluding the real estate sales from their net earnings computation and by reporting the sales as capital gains not subject to a tax on the net earnings. Based on Code Secs. 1401(a) and (b), which impose a tax on the net earnings from self-employment derived from any trade or business carried on by the taxpayer, and the court's findings that the taxpayers earned income from the proceeds of sales of real properties, the court held that the taxpayers should have included the income in their reported net earnings from self-employment.

For a discussion of capital assets, see Parker Tax ¶ 111,105. (Staff Editor Parker Tax Publishing)

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.

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