Real Estate Received Due to Business of Acquiring Tax Liens Was Inventory, Gains on Sale Not Capital

In the case of SI Boo v. Commissioner, TC Memo 2015-19 the proper tax treatment of real property sales from property obtained by the taxpayer due to their business of acquiring Illinois tax liens was in question. 

Under the state law rules in question the taxpayer would bid on judgment tax liens at auction.  Bidders would bid a “penalty percentage” rate ranging from 18% to 0%, with the lowest bidder receiving the lien in question. The winner of the bid process pays the taxes due and receives a certificate of lien.

The property owner effectively then has three years during which he/she retains the right to remove the lien and retain the property by paying the tax due plus interest based on the penalty rate and other costs imposed by statute.  For the first six months the interest rate is the bid penalty rate.  For the period from six months until a year from the date of sale the rate is double the bid penalty rate. 

The rate continues to go up, eventually maxing out at a rate that six times the penalty rate for the period from 30 to 36 months after the date of sale.  If 36 months pass from the date of sale of the lien, the holder of the lien can petition for a tax deed on the property, receiving merchantable title that is free and clear from all other claims.

The taxpayer in this case regularly bid upon and obtained such liens.  In the majority of cases the property holder would eventually pay off the balance due to release the liens, but in a few cases the partnership would end up taking the real estate.  In such cases it looked to dispose of the property rapidly and did not hold the property for appreciation.

On the partnership tax returns, the taxpayer reported general income from its tax lien business as ordinary income offset by business deductions, resulting in net income or loss from self-employment.  It reported the sale of the real property as generating capital gain or loss.  When it sold real property over time and carried the note, any gains on those sales were reported on the installment basis.  Similarly, these capital gains or losses were not included in the computation of self-employment income or loss for the year.

The IRS challenged the tax treatment of the sale of real estate by the taxpayer.  The IRS argued the real estate constituted property held for sale to customers in the regular course of the taxpayer’s business.  Sales of such property would generate ordinary income or loss, not capital gain income or loss.  As well, the partnership would be a dealer in such property prohibited from using the installment basis of reporting gains on any sales under IRC §453(l).  Such income or loss would also be counted in computing self-employment income or loss for the year.

The key issue on which the case turns regards whether the land represented property held primarily for sale to customers in the ordinary course of the partnership’s trade or business. Under IRC §1221(a)(1) such property is excluded from the definition of property that is a capital asset, so that the sale of such property would generate ordinary income and not capital gains.

IRC §453(b)(2)(A) prohibits the use of the installment method for income from a dealer disposition, which includes any real property held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business. [IRC §453(l)(1)(B)]  Similarly, IRC §1402(a) includes in the computation of self-employment income amounts earnings from any trade or business carried on by the taxpayer.

So the key question was—were these properties, acquired as a by-product of the entity’s tax lien operation, held for sale to customers in the ordinary course of the taxpayer’s trade or business?

The Tax Court notes that, generally, the following factors are considered in determining if property is held primarily for sale in the taxpayer’s trade or business:

  • The frequency and regularity of sales of real properties;
  • The substantiality of the sales and the relative amounts of income taxpayers derived from their regular business and the sales of real properties;
  • The length of time the taxpayers held the real properties;
  • The nature and extent of the taxpayers’ business and the relationship of the real properties to that business;
  • The purpose for which the taxpayers acquired and held the real properties before sale;
  • The extent of the taxpayers’ efforts to sell the property by advertising or otherwise; and
  • Any improvements the taxpayers made to the real properties.

The court will look at the factors it deems relevant for the particular case it is deciding and, considering the issue as a whole, determine if the property was held primarily for sale to customers in the ordinary course of business.

In this case the Court decided that the facts indicated this property was held primarily for sale to customers in the ordinary course of its business.

Issues the court considered included:

  • Although the entities acquired far more liens than properties annually, they still ended up with a number of properties each year.  The entities admitted it was their intent to dispose of such properties quickly, and the vast majority were held for less than one year.  Sales of far fewer properties annually had been found in earlier cases to constitute frequent and regular sales.
  • When compared to the amount of income earned each year, the income generated from the sales of the real property made up a far greater percentage of income than the simple ratio of properties acquired vs. tax liens acquired.  In fact, being able to turn these properties quickly and at a profit was a very significant factor in the profitability (or lack thereof) of the lien business they ran.
  • The entities employed persons or had employees from other entities act for or on their behalf in acquiring tax deeds, preparing properties for sale and maintain records

Based on these findings, the Court found that the taxpayers were selling inventory and not capital assets when they disposed of the real property.  Thus the income was ordinary income and subject to self-employment tax.

As well, the taxpayer was forced to change its method of accounting for real estate sales from the installment method to a full accrual method where all income is recognized at the time the property is sold.  Being that this was an accounting method change, the taxpayer had to recognize the previously unrealized income deferred from sales in prior years as a §481(a) adjustment.