The question of whether real estate was or was not a capital asset in the hands of the taxpayer was the key issue in the case of Keefe v. Commissioner,[1] CA2, Case Nos. 18-2357, 18-2594, affirming TC Memo 2018-28.  This issue comes up often with real estate, with taxpayers having a particular interest when they are unable to recover what they had invested in the property upon disposing of it.

Following a loss in the Tax Court, a case we had previously written about when originally decided in March of 2018 (Mansion Property Was Never Actually Used in a Rental Activity, Loss Was Capital), the taxpayers appealed the decision to the Second Circuit Court of Appeals

The taxpayers appealed the Tax Court decision to the Second Circuit Court of Appeals, arguing the Tax Court had misapplied the case law interpreting the application of §§1221(a)(2) and 1231 when determining the house had not been used in a trade or business—specifically the trade or business of renting out real property.

The Second Circuit panel begins by looking at the standard for determining if there was a rental trade or business being undertaken:

Real estate rental is considered a “trade or business if the taxpayer-lessor engages in regular and continuous activity in relation to [renting] the property.” Although we have not identified an exhaustive list of factors to be used in this determination, we have considered the following: whether the taxpayer (or an agent) performs maintenance and repairs, whether the taxpayer employs labor to manage the property or provide tenant services, and whether the taxpayer purchases materials, collects rent, and pays expenses. The tax court also considered petitioners' efforts to rent the property.

The panel concludes that, in fact, there was no trade or business conducted.  The panel notes:

Applying this framework, we conclude that petitioners did not engage in “regular and continuous” rental activities because, as the tax court explained, they never commenced rental activity in a meaningful or substantive way. They did not advertise Wrentham House online, sign a lease with any potential tenant, furnish the property for rent after it was ready to occupy, comply with the notice and registration steps required by the declaration of condominium to rent the property, or receive any rental payments or security deposits.

The panel notes that there were only limited attempts to rent the property, but continuous efforts to sell the property:

Petitioners did take some limited steps toward renting the property by engaging the rental agent, Burke. Burke first visited the house in 2006. Throughout 2007 and into 2008, she discussed prospective rentals with clients, including the one client who expressed interest but ultimately decided not to rent. But these rental efforts occurred only before the house was ready to occupy; Burke never listed the rental online, and the house was not held out for rent at any time after the restoration was complete.

Petitioners’ insignificant efforts to rent Wrentham House stand in contrast to their significant efforts to sell it. Petitioners listed the house for sale continuously from 2004 to its ultimate sale in 2009, except for one week in 2008. Petitioners had the house appraised in 2005 and adjusted the list price at least five times, which suggests they were making real efforts to sell the property rather than creating a nominal listing simply because Bank of America required it for petitioners to take out a second mortgage.

The Court also took notice of the fact that although two tax credits were available for restoring the historic property, the taxpayers only pursued the one that was not contingent on renting the property:

In addition, petitioners’ knowledge of the state and federal tax credits does not evince regular and continuous activity to rent the property. The state tax credit did not contain a rental requirement, so the fact that petitioners completed some steps toward obtaining that credit does not constitute any substantial step toward renting the property. Although petitioners were aware of the federal tax credit, which contained a rental requirement, they never sought it.

[1] Keefe v. Commissioner, CA2, July 17, 2020, https://www.ca2.uscourts.gov/decisions/isysquery/52af8fdb-0613-403b-a2f2-38621bb35839/6/doc/18-2357_opn.pdf#xml=https://www.ca2.uscourts.gov/decisions/isysquery/52af8fdb-0613-403b-a2f2-38621bb35839/6/hilite/ (retrieved July 20, 2020)