Evans v. Commissioner, T.C. Memo. 2016-7, was recently decided.

The taxpayer in this case was an individual who worked full-time at a real estate development firm.  The taxpayer also purchased residential real estate properties in his individual capacity to develop and then sell or rent.  One such property was located in Newport Beach.  The taxpayer purchased the property for $1,400,000; he intended to demolish the existing structures, build a home, and then sell the property outright or, alternatively, rent the property to tenants.  In 2007, the taxpayer borrowed $250,000 from a third party; pursuant to the loan agreement, the lender obtained a lien on the Newport Beach property.  When the taxpayer defaulted, the lender foreclosed on the loan and the property was sold in 2008 in a nonjudicial foreclose sale for $556,000.  From the sale proceeds, $250,000 was used to satisfy the debt.  In 2009, the taxpayer contacted the trustee who sold the property requesting the excess proceeds; he subsequently signed a release, discharge, and indemnity agreement and received the remaining $280,325 of proceeds in early 2009.  The taxpayer reported an ordinary loss from the forced sale of the Newport Beach property on his Federal income tax return for 2008.  

Generally, any property held by the taxpayer is a capital asset unless the property satisfies one of the statutory exceptions.  The relevant statutory provision includes an exception for “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”  I.R.C. § 1221(a)(1).  In determining whether property is a held for sale in the ordinary course of business, courts review: (1) the acquisition of the property; (2) the frequency and continuity of sales of similar property; (3) the nature and extent of the taxpayer’s trade or business; (4) the taxpayer’s activities with respect to the property; and (5) the extent and nature of the taxpayer’s transactions in the trade or business.

When a property is sold in a foreclosure sale, a loss from the sale is incurred when the property is sold and the debt is discharged by the proceeds of the sale.  If the taxpayer has a right of redemption with respect to the property or if there is ongoing litigation regarding the foreclosure, then the foreclosure sale is not final and no loss is incurred until the taxpayer’s right expires or the litigation is resolved.

The court found that the taxpayer’s intention with respect to the Newport Beach property was not dispositive as to whether the property was a capital asset.  The court focused on the fact that the taxpayer failed to show that he regularly sold similar property – although he testified that he had acquired multiple properties, the court found evidence of only two sales of real property.  This was insufficient to establish a trade or business.  Although the taxpayer took specific actions (such as hiring contractors) to sell the property, the court further held that he was not actively and regularly engaged in a trade or business of selling real property because these actions were isolated and sporadic.  Accordingly, the court held that the Newport Beach property constituted a capital asset in the hands of the taxpayer.  

The court further held that under California law, the taxpayer had no right to redemption with respect to the Newport Beach property.  Even though the taxpayer did not receive the excess proceeds until 2009, the taxpayer incurred the loss in 2008 when the foreclosure sale occurred and the proceeds were used to discharge the debt.  The court applied this principle even though the taxpayer argued that he did not have notice of the existence of the excess proceeds until 2009.  

The Evans case highlights two frequent (and important) issues in real property transactions: the timing and nature of a loss with respect to the sale of real property.  Individuals who engage in infrequent purchases and sales of real property should be aware of the facts of this case and the general factors that courts review in determining whether an asset is a capital asset.  In addition, infrequent sellers and real estate professionals should be advised of the Tax Court’s decision that the taxpayer’s loss here was incurred in the year of the foreclosure sale and such loss was reduced by the excess proceeds distributed to the taxpayer, even though the distribution did not occur until the year after the sale.

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation.

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