Tax Court in Brief | Musselwhite v. Commissioner | Loss in Sale of Real Estate: Ordinary Loss or Capital Loss?

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Tax Litigation:  The Week of June 6th, 2022, through June 10th, 2022

Musselwhite v. Commissioner, T.C. Memo. 2022-57 | June 8, 2022 | Ashford, J.| Dkt. No. 14380-16

Summary: William Musselwhite was involved in real estate ventures since about 1986. In 2005, Musselwhite and his business partner formed DS & EM Investments, LLC (DS&EM). In 2006, DS&EM purchased 4 unimproved lots for $1 million from Adam Lisk. DS&EM re-platted the 4 lots into 9. The terms of agreement with Lisk included certain guarantees-of-resale-within-one-year, allocation of ownership of the 9 lots (4 with DS&EM and 5 with Lisk), buy-back provisions, and other conditions relating to the development and sale of the lots, including that Lisk would complete improvements on some of them. DS&EM financed the purchase price with a loan from BB&T Bank. In 2007, the real estate market crashed, and due to incomplete improvements and lack of sales per the deal, DS&EM sued Lisk. In 2008, and in order to resolve the lawsuit, Lisk transferred his 5 lots (now partially improved) to DS&EM. Thereafter, no improvements were made to those 5 lots and the development activities all but ceased. BB&T subsequent appraisals of the lots indicated that the property was not known to be for sale. Due to the depressed real estate market, DS&EM and its two members (Musselwhite and his business partner) divided up their various properties and debts, and DS&EM distributed the 4-of-9 lots to Musselwhite. Within 4 months of receiving the 4 lots, Musselwhite sold them for $17,500, realizing a loss of $1,022,726. On Musselwhite’s 2012 Form 1040, he (and his wife filing jointly) reported a Schedule C business loss deduction loss of $1,022,726 relating to the sale of the 4 lots which Musselwhite reported as cost of goods sold. Following an exam of Musselwhite’s 2012 Form 1040, the IRS determined that Musselwhite was not entitled to the reported $1,022,726 Schedule C loss because the 4 lots were capital assets and thus their sale generated a capital (and not ordinary) loss. A notice of deficiency was issued, and the matter was petitioned to the Tax Court for review.

Key Issues:

Primary Holdings:

Key Points of Law:

Insights: Real estate may constitute inventory, rather than a capital asset, for federal tax gain and loss purposes. Section 1221(a)(1) of the Code is the applicable statute for evaluating tax treatment of such gain or loss. To constitute a stock in trade of the taxpayer, the taxpayer must hold the real estate primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. A taxpayer may hold real estate primarily for sale to customers in the ordinary course of the taxpayer’s trade or business and, at the same time, hold other real estate for investment. And, a property once held as inventory for sale to customers may change in character for federal income tax purposes, depending on the application of factors developed and used by the Tax Court.

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