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Tax Court Rejects Partnership's Attempt to Treat Land Sold at a Loss as Inventory

(Parker Tax Publishing June 2022)

The Tax Court held that a taxpayer, a personal injury lawyer who also invested in real estate and received a distribution of land via a partnership in which he was a member, could not treat a loss incurred on the subsequent sale of land as an ordinary loss from the sale of inventory under Code Sec. 1221(a)(1). The court found that the partnership initially acquired and subsequently held the property for investment and that no change in purpose occurred when the partnership distributed the property to the taxpayer. Musselwhite v. Comm'r, T.C. Memo. 2022-57.


William Musselwhite is a personal injury lawyer in Lumberton, North Carolina. In addition to practicing law, Musselwhite has been involved in several real estate ventures dating back to the 1980s. In 2005, Musselwhite and David Stephenson, a real estate developer, formed a two-member limited liability company called DS & EM Investments (the partnership). The partnership's 2005 annual report filed with the state of North Carolina, as well as its annual reports for years 2006-2012 (LLC reports), indicated that the nature of its business was real estate investment. The partnership initially purchased for investment five condominiums; they immediately sold two. The partnership also acquired for investment purposes undeveloped lots in Lumberton and in the Seawatch subdivision in Brunswick County, North Carolina, and a house in Wilmington (Wilmington House).

In 2006, the partnership entered into an agreement with Adam Lisk, a real estate developer. Under the agreement, Lisk purchased the Wilmington House and the partnership purchased four of nine undeveloped wooded lots that Lisk owned. Lisk personally guaranteed that the four lots would sell within one year or he would buy back the remaining unsold lots. Lisk also agreed that he and his real estate agent would market the lots and that Lisk would complete certain developments on the lots. The partnership purchased the four lots from Lisk in August 2006 for $1 million. The purchase was partially financed by a loan from BB&T Bank (BB&T).

In 2007, the real estate market across the country began to take an ugly turn. It was even worse in Brunswick County because the developer of the Seawatch subdivision, Mark Saunders, had not completed all the improvements he had promised; consequently, he was being sued by multiple landowners, and he had started to flood the market in Brunswick County with hundreds of distressed properties. Lisk slowed on completing the improvements for the lots. He had multiple other business partners filing for bankruptcy or having serious financial problems, and he started having financial problems himself.

The four lots did not sell within one year. In November 2007, the partnership sued Lisk for breach of contract. Ultimately, the parties agreed that Lisk would complete the rest of the improvements in exchange for the partnership dropping the lawsuit. As of December 2008, Lisk made various improvements to the lots, including removing trees, completing grading, and building a road. The partnership made no improvements to the lots after that time other than occasional cleanup.

BB&T had appraisals prepared with respect to the four lots in 2011 and 2012 which stated that the lots were not known to be currently for sale. In light of the continued depressed housing market and BB&T's mounting pressure, Musselwhite and Stephenson agreed that it was prudent to distribute or convey to each other some of their properties (including properties of the partnership), dividing up the debt. In July 2012, the partnership distributed the four lots to Musselwhite. Musselwhite hired a broker to market the lots and bring them to sale. The broker spent substantial time and effort marketing the lots for sale. Ultimately, in November 2012 Musselwhite sold the four lots for a total of $17,500, resulting in a $1,022,726 loss.

The partnership's Forms 1065 for years 2005-2012 reported that its principal business activity was investment and its principal product or service was property. The partnership's 2005-2010 returns reported that it had "no inventories" and that its "other investments" included "investment real estate." It was on the partnership's 2011 Form 1065 that the four lots were first reported as being held as inventory at the beginning and end of the tax year. Musselwhite and his wife filed a joint return for 2012 reporting income from Musselwhite's law firm which was offset by a deduction for an ordinary loss from the sale of the four lots. In a notice of deficiency, the IRS determined that the Musselwhites were not entitled to take an ordinary loss for the sale of the four lots because the lots were capital assets. The Musselwhites took their case to the Tax Court.

Under Code Sec. 1221(a), a capital asset is any property held by the taxpayer, whether or not connected with a trade or business, other than certain types of property. Code Sec. 1221(a)(1) excludes from the definition of a capital asset 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 tax year, or property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business. In Graves v. Comm'r, 867 F.2d 199 (4th Cir. 1989), the Fourth Circuit held that several factors are relevant in resolving whether property is described in Code Sec. 1221(a)(1). Among the factors to be considered are: (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. No one factor is determinative, and not all factors may be relevant in a particular case.


The Tax Court held that the Musselwhites' loss was a capital rather than ordinary loss after finding that all of the Graves factors weighed in favor of capital asset treatment other than the fact that Musselwhite's broker spent substantial time and effort marketing the lots for sale.

The court found that the four lots were initially acquired and subsequently held for investment purposes. The court noted that Musselwhite acquired the four lots via a distribution from the partnership as part of an agreement with Stephenson to deal with the mounting pressure from BB&T as well as his and Stephenson's personal debt exposure. The court found that Musselwhite had no intention whatsoever of developing the lots when he acquired them and thereafter while holding them, and he never undertook any development of the lots during the few months he held them before they were sold - investment was his principal (really sole) purpose. Indeed, the court noted that as part of the agreement with Stephenson, the partnership also distributed a condominium to Musselwhite which, like the four lots, Musselwhite sold in 2012 and reported as a Schedule D (capital) loss.

Furthermore, the court found that there was no change in purpose when the four lots were distributed to Musselwhite. The court was "very much convinced" that the partnership purchased and held the lots for investment, the same purpose it had with respect to all of its property. Musselwhite testified that everything he and Stephenson did through their partnership was "really investment" and that specifically with respect to the partnership's acquisition of the four lots, it was an opportunity to invest in a subdivision that Lisk (an established developer) was already developing. The court noted that his testimony was consistent with the representations made on the partnership's 2005-2012 Forms 1065 that its principal business activity was investment and its 2005-2012 LLC reports that its business was real estate investment. In addition, the 2005-2012 Forms 1065 reported no gross receipts or sales, but sales of real property were reported on several of these forms (as well as detailed on Schedules D). Further, the August 2006 agreement between the partnership and Lisk showed that the partnership had no responsibility at all for developing and marketing the four lots.

The court further found that, even if the partnership acquired the four lots in 2006 for development purposes, all the evidence showed that it abandoned its development plan by the end of 2008. The court noted that as of that time, Lisk had completed certain development actions but had no further involvement with the subdivision and the partnership did nothing to improve any of the lots or market them for sale. Indeed, the court observed that BB&T's appraisals recited that the lots were not listed for sale at the time the appraisals were made.

The court went on to find that the extent of improvements favored capital asset treatment since, as noted above, no improvements were made after December 2008 by the partnership or by Musselwhite. The isolated nature of Musselwhite's sale of the four lots, rather than an ongoing proprietorship engaged in activities relating to real estate, along with the fact that Musselwhite's everyday business was not the development and sale of real estate, also weighed in favor of capital asset treatment. The court concluded that the overwhelming weight of the factors was against Musselwhite and in favor of the IRS.

For a discussion of stock in trade, inventory, and other property held primarily for sale to customers, see Parker Tax ¶111,105.

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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