The question of whether real estate was or was not a capital asset in the hands of the taxpayer became an issue in the case of Keefe v. Commissioner, TC Memo 2018-28. While the issue can arise with other assets, real estate investments are generally large enough that the question of whether a gain or loss on sale is capital, §1231 or ordinary is often a very significant issue, with high stakes involved.

In this case, the taxpayer was looking at a seven-figure loss on the sale of a historic waterfront mansion they had acquired to restore and attempt to rent in Newport, Rhode Island. The restoration ended up taking much longer than anticipated and was far costlier. Although they talked with a real estate agent about renting out the property to wealthy individuals who were expected to pay $75,000 a month for the property during peak season, it was never actually rented out.

While the property was not formally listed for rent, the agent did talk with some of her clients about the potential to rent this property and one expressed interest in doing so. But the fact that the restoration was not yet complete meant the property was not actually available for rent during the vast majority of time the agent talked to her clients about doing so. Eventually the taxpayer abandoned attempts to rent out the house due to simple economic issues.

The taxpayers ran into financial difficulties in continuing the project, with the bank increasing the taxpayer’s required monthly payment on the financing provided from $25,000 to $39,000 per month. The taxpayers decided to simply attempt to sell off the property, eventually agreeing to a short sale of the mansion for $6.5 million.

The preparer of the taxpayer’s original 2009 return listed the loss on sale as a capital loss which limited the actual ability to offset income other than capital gains to $3,000 per year—a pittance when there is a seven-figure loss.

An estate planner the taxpayers met with apparently caused the taxpayer to question the preparer’s treatment of the loss as a capital loss. Following that meeting the taxpayers hired another firm to prepare amended income tax returns. On the amended return for the year of sale, the taxpayers now treated the transaction as sale of a §1231 asset, generating a large ordinary loss and a similarly large net operating loss, which was carried back to 2004 and forward to 2010.

Though the IRS initially issued the refunds, the IRS later examined the 2009 return and took the position that, in fact, the loss was not a §1231 loss, but rather this was the sale of a capital asset.

The Tax Court, citing Second Circuit precedent, noted that for the property to be treated as property used in a trade or business the taxpayers must be engaged in “continuous, regular, and substantial activity in relation to the management of the property” as part of the rental activity.

The Court found that, in fact, there never was a rental activity. The Court notes:

While we have no doubt that petitioners devoted a great deal of time, effort, and expense to the renovation of Wrentham House Mansion, the record overwhelmingly confirms that Wrentham House Mansion was never held out for rent or rented after the restoration was complete. Quite simply, the rental activity with respect to Wrentham House Mansion never commenced in any meaningful or substantive way. The cases on which petitioners rely are distinguishable because in each case where a rental trade or business was found to exist, the taxpayer had already started the rental activity and had provided substantial and continuous rental-related services. See Alvary, 302 F.2d at 796; Gilford v. Commissioner, 201 F.2d at 736; Pinchot v. Commissioner, 113 F.2d at 719. In contrast, petitioners never started a rental trade or business involving Wrentham House Mansion. Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other grounds, 382 U.S. 68 (1965); Glotov v. Commissioner, T.C. Memo. 2007-147, slip op. at 5 (holding that a taxpayer is not carrying on a trade or business until the business is functioning as a going concern and performing the activities for which it was organized).

Because petitioners did not commence or operate a rental activity with respect to Wrentham House Mansion during the years at issue, we hold that Wrentham House Mansion was a capital asset at the time of its sale. It follows that any gain or loss was derived from the sale of a capital asset and respondent properly disallowed the NOL carryovers.

The Court also sustained the imposition of the accuracy related penalty on the taxpayers in this case, finding they had not reasonably relied upon the advice of a professional:

Petitioners failed to prove that they had reasonable cause and acted in good faith within the meaning of section 6664(c)(1). Petitioners did not make a reasonable, good-faith effort to correctly assess their tax liabilities and their claimed reliance on a tax professional was both unreasonable and not credible. Petitioners' attempt to recharacterize the tax treatment of their investment in Wrentham House Mansion was opportunistic and appears to have been motivated by their financial problems and unpaid income tax liabilities. This attempted recharacterization had all the markings of being “too good to be true”, yet petitioners forged ahead, knowing that they had never actually commenced a rental activity involving Wrentham House Mansion and had not done all of the things the law required to be able to rent Wrentham House Mansion. Because petitioners failed to prove that they had reasonable cause for, and acted in good faith with respect to, the positions taken on their amended income tax returns and on their only return for 2010, we sustain respondent's determination that they are liable for the section 6662 accuracy-related penalties.

While the Court doesn’t go into details regarding this matter, courts have often been less than sympathetic when a taxpayer gets conflicting advice on a position from professionals, then simply decides to believe the professional who comes up with most economically favorable answer.

The problem is that, to be able to rely on a professional, the taxpayer must make a reasonable attempt to determine which piece of advice is more credible. The burden is on the taxpayer to come up with a reason other than the tax savings for the reason they elected to believe the adviser for some reason other than getting a big refund when they followed that advice.