During the first week of teaching federal income tax I give a homework assignment where I ask students to compare the 2011 tax returns of Mitt Romney and Hillary Clinton. Students must decide who had the heavier tax burden. You can find these returns (and many more) on the Tax Analyst Tax History website. Here’s what we usually come up with in class:
||% of Total Inc.
||% of Taxable Inc.
My students are surprised by this result. Although they had similar total incomes, Romney and Clinton paid hugely different amounts and percentages of taxes no matter how you measure tax burden. But there is nothing nefarious about it. It simply reflects Congressional choice to tax capital gains at a lower rate than ordinary income.
To get the lower tax rate the gain must come from a sale or exchange of something called a “capital asset” that has been held for more than one year. Romney’s income came mostly from sales or exchanges of capital assets while Clinton’s came mostly from her labor. That difference in source made the difference in tax. Whatever one thinks about Clinton’s speaking fees, they still resulted from her labor and so were taxed at significantly higher rates than Romney’s capital gain income, even though dollars derived from labor have the same purchasing power as dollars derived from capital.
This preferential tax treatment for capital gains over labor income is a subsidy whereby Congress shifts dollars from one set of taxpayers (those like Clinton) to another set of taxpayers (those like Romney). It’s a subsidy just like the Earned Income Tax Credit (EITC) except that the EITC shifts dollars from higher earning taxpayers to lower earning taxpayers. So who does Uncle Sugar love more? Why, folks like Romney!! In 2016 the federal government spent about $106 billion to subsidize taxpayers who, like Romney, received income from capital sales or exchanges. In comparison, it spent $63 billion on the EITC subsidy. You can see these figures in the JCT’s latest Estimates of Federal Tax Expenditures.
Congress does put some restrictions on this rate subsidy. For example, §1211 generally prevents taxpayers from deducting capital losses against ordinary income. After all, if a gain from the sale or exchange of a capital asset gets a lower rate, then a resulting loss should not be able to shelter otherwise higher taxed gain but only similarly taxed gains.
So when taxpayers have gain from the sale of some kind of property held for more than one year, they really want that lower tax rate. They want their gains to be from the sale of a capital asset. Contrariwise, when taxpayers have losses from the sale of some kind of property, taxpayers would really like to deduct those losses from their ordinary income, the kind that gets taxed at a higher rate. They want those losses to be from the same of property that is not a capital asset.
So what the heck is a “capital asset”? That is the lesson in Sugar Land Ranch Development, LLC, Sugar Land Advisors, LLC, Tax Matters Partner v. Commissioner, T.C. Memo 2018-21 (February 22, 2018). There, the taxpayers were able to transform properties that did not qualify as capital assets before 2008 into properties that did qualify as capital assets when they sold the properties for a net gain in 2012. So they got the rate subsidy. How’d they do that? Details below the fold, along with the Tax Lawyer’s Wedding Toast.
Section 1221(a) broadly defines the term “capital asset” as all property held by the taxpayer and then gives eight exceptions. The first exception, §1221(a)(1), provides that property that is either inventory or like inventory cannot qualify as a “capital asset.” In particular, §1221(a)(1) says a capital asset is not going to be “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”
Whether a landowner is holding land primarily for sale to customers just...depends. As the 10th Circuit put in in the classic case of Mauldin v. Commissioner, 195 F.2d 714 (1952): “There is no fixed formula or rule of thumb for determining whether property sold by the taxpayer was held by him primarily for sale to customers in the ordinary course of his trade or business. Each case must, in the last analysis, rest upon its own facts.” The Tax Court here used the same idea expressed by the Fifth Circuit (where any appeal would go) in Suburban Realty Co., v. United States, 615 F.2d 171 (5th Cir. 1980).
So here are the facts:
The taxpayers here formed a partnership in 1998 to buy and develop land outside of Houston for the purpose of turning that land into housing developments and commercial developments. The partnership acquired various parcels of land totaling about 950 acres. The land had been a former oil field and so over the years the partnership cleaned up the land, built a levee, and entered into development contract with the city of Sugar Land, Texas to set up the rules for developing the lots.
By 2008 the partnership had done a lot of work developing the land. It then pretty much stopped doing any more work and it was not until 2012 that the partnership sold any significant part of the land. In that year it sold two parcels (about 530 acres) to a homebuilding company, Taylor Morrison (TM). TM paid a lump sum for each parcel and also agreed to make future payments relating to the expected development: a flat fee for each plat recorded and 2% of the final sales price of each house developed on one of the parcels.
The partnership reported an $11 million gain from the sale of one parcel and a $1.6 million loss on the other parcel. It took the position that the land sold was a “capital asset” and so the gains and losses were capital gains and losses. The IRS disagreed and thought the land did not qualify as a capital asset. The partnership hired George Connelly of Chamberlain Hrdlicka to litigate the matter in Tax Court. We’ve met George before, in a case which had less happy results. This time around, the parties ended up before Judge Thornton.
At first blush these facts would seem to support the IRS view that the land here was not a capital asset. Heck, just go look at the name of the partnership! The partnership’s entire purpose was to develop the land primarily for sale to customers to build homes.
But notice the dates. Then go watch “The Big Short.” What George needed to do was to convince Judge Thornton that even though the partnership had originally acquired the property to sell to customers in the ordinary course of business, circumstances in 2008 had forced it to change its plans. He was able to do that, thanks in large part to credible testimony from the two managing partners and a contemporaneous Unanimous Consent dated December 16, 2008, declaring that the partnership would no longer attempt to develop the land but would instead hold the land until the real estate market recovered enough to sell at a profit. The partnership had also never actually subdivided the property into separate lots. While subdivision is not the be all and end all of factors, it is still such an important factor that Congress actually wrote a special statute, §1237, to say that land does not automatically lose its status as a capital asset just because a taxpayer subdivides it.
The IRS attorneys, Candace Williams and Carol McClure, did their best to point out all the facts showing continuing development activities and they tried to tie these 2012 sales to other sales. But Judge Thornton was not buying what they were selling. The opinion carefully explains why the facts the IRS raises do not overcome the facts presented by the taxpayers. Ultimately, Judge Thornton agreed that the partnership had successfully changed its operations after 2008 from developer to investor such that the land it sold in 2012 was a capital asset.
Coda, The Tax Lawyer’s Wedding Toast: As I take my class through the study of capital gains, they quickly get the idea of why taxpayers want gains to be capital in character and losses to be ordinary in character. The word “capital” has other meanings, of course. It can mean “splendid” or “good” and some non tax lawyers may well hear it that way, especially if they are English. Likewise, non tax layers hear the word “ordinary” and probably think it means “common” or “everyday.” So it is quite fitting that if you ever attend a tax lawyer’s wedding, you offer the following toast that will speak to everyone: “To the happy couple! May all their gains be capital and all their losses ordinary!” I certainly hope the happy taxpayers here toasted George.