The Housing Market[i]

During the first quarter of 2022, the housing market accounted for 16.7 percent of gross domestic product (“GDP”).[ii] This figure represents a return to historic norms following the substantial reduction in housing’s share of GDP after the Great Recession.

The reasons cited for the increase include the imbalance in supply and demand for housing, which itself resulted from the reduction in inventory following the 2007-2009 recession and the housing bubble burst[iii] and the recent wave of millennials who, encouraged by what has been until now a low interest rate environment created by the Federal Reserve in response to the pandemic,[iv] have been looking to purchase their first homes.[v]
Over the last few weeks, several industry forecasters have stated that, because of rising mortgage rates, they anticipate price growth will fall throughout the second half of 2022, before leveling off somewhere between 4 percent and 5 percent annual growth in 2023.[vi]

The Dallas Fed’s Report

There is one key industry observer, however, which is not as positive as the other forecasters: The Federal Reserve Bank of Dallas.[vii] According to its recent report,[viii] there is “evidence [that] points to abnormal U.S. housing market behavior for the first time since the boom of the early 2000s. Reasons for concern are clear in certain economic indicators – the price-to-rent ratio, in particular, and the price-to-income ratio – which show signs that 2021 house prices appear increasingly out of step with fundamentals.”[ix]

The report then states that “real house prices can diverge from market fundamentals when there is widespread belief that today’s robust price increases will continue. If many buyers share this belief, purchases arising from a ‘fear of missing out’ can drive up prices and heighten expectations of strong house-price gains.”

“This self-fulfilling mechanism,” the Fed’s report continues, “leads to price growth that may become exponential (or explosive), resulting in the housing market becoming progressively misaligned from fundamentals until investors become cautious, policymakers intervene, the flow of money into housing dries up and a housing correction or even a bust occurs.”[x]

The report concludes, however, that “[b]ased on present evidence, there is no expectation that fallout from a housing correction would be comparable to the 2007–09 Global Financial Crisis in terms of magnitude or macroeconomic gravity.”

That said, the fact remains that the housing market plays an important role in the economy.[xi]

What Does it Mean?

Hopefully, the worst-case scenario described in the Dallas Fed’s report does not materialize. However, if it turns out that the Delphic Oracle has abandoned the slopes of Mount Parnassos for the mostly flat area surrounding Dallas, some real estate investors may, unfortunately, find themselves in the position of a taxpayer who recently argued unsuccessfully in the U.S. Tax Court that the loss they suffered in various residential development projects constituted ordinary losses.[xii]

Taxpayer’s Investment

Taxpayer was an attorney who, over the years, also became involved in various real estate ventures.[xiii] Taxpayer eventually partnered with a successful business owner who was experienced in real estate development. The two of them formed Investment LLC.

The LLC initially purchased five condominiums for investment, though it immediately sold two. Investment LLC also acquired certain undeveloped lots for investment purposes.[xiv]

The Lots

It wasn’t long before another real estate developer (“Developer”) contacted Investment LLC, proposing an arrangement whereby the LLC would purchase four undeveloped lots (the “Lots”) in a subdivision that Developer owned.[xv] From Taxpayer’s perspective, the arrangement was an opportunity to invest in a subdivision that Developer was already developing. Developer agreed to give Investment LLC a personal guaranty that the Lots would sell within one year and the LLC would net at least $1 million from the sales, or Developer would buy back the unsold lots. Additionally, Developer and the LLC agreed to split equally any additional profit from the sales. Developer also agreed to market all nine lots and agreed to complete certain improvements to all the lots to facilitate their sale.

In accordance with the agreement, Investment LLC purchased the Lots from Developer for $1 million. The LLC partially financed its purchase with a loan from Bank, which was secured by a deed of trust covering the Lots in favor of Bank.

The Great Recession

In 2007, as we know, the real estate market began to take an ugly turn. Developer felt the crunch of the downward-spiraling real estate market and, consequently, deferred completing the improvements for the Lots.

The Lots did not sell within one year, and Investment LLC filed a complaint against Developer, alleging a breach of their agreement in that Developer had failed to (1) complete all planned improvements, (2) properly market the Lots, and (3) buy back the Lots.

Ultimately, Investment LLC and Developer came to an agreement resolving their dispute, pursuant to which Developer agreed to complete the rest of the improvements and transfer the remaining five lots to the LLC so that the LLC would have the whole subdivision. By the end of 2008, Developer had completed many improvements to the Lots. No further improvements were made to the Lots by the LLC, nor did LLC market the Lots.

Indeed, appraisals subsequently commissioned by Bank with respect to the Lots (in 2009, 2011, and 2012) each recited that “The subject has no known prior sales history within the past 3 years and is not known to be currently for sale.”

In light of the continued depressed housing market, Bank’s mounting pressure with respect to the Lots as the holder of a deed of trust covering these lots, and Taxpayer’s personal debt exposure with respect to certain other investments, in 2012 Taxpayer and his partner in the LLC caused the LLC to distribute the Lots to Taxpayer and other properties to his partner, thereby dividing the LLC’s debt between them.

Taxpayer then hired Broker to market the Lots and bring them to sale. Broker immediately began to aggressively market the Lots and explore various options for their disposition. Shortly thereafter, Taxpayer sold the Lots for a substantial loss.

Tax Returns

Investment LLC’s first annual report filed with State indicated that the nature of its business was real estate investment. Subsequent reports continued to report the nature of Investment LLC’s business as real estate investment.

Similarly, Investment LLC’s federal partnership tax returns, on IRS Form 1065, U.S. Return of Partnership Income, for almost every year until the year in question reported that Investment LLC’s principal business activity was “Investment,” and its principal product or service was “Property”; these returns also reported that the LLC had no gross receipts or sales.[xvi] However, capital gains and/or losses with respect to sales of real property were reported on the returns for many of the years preceding and also including the year in question.[xvii]

The Schedules L, Balance Sheets, included with these returns reported that Investment LLC had no “[i]nventories”; these Schedules L reflected that the LLC had “[o]ther investments,” which included “Investment-Real Estate.”

However, Investment LLC’s Schedule L for the year immediately preceding the year in question (2011 and 2012, respectively) was the first on which the Lots were reported as being held as “[i]nventories.” When the LLC’s 2011 Form 1065 was filed in 2012, the LLC and Taxpayer were aware that the fair market values of the nine lots (the Lots plus the five acquired from Developer) were less than Investment LLC’s total basis in the lots.[xviii] The Schedule L for the 2012 Form 1065 also reported “[i]nventories” at the beginning of the taxable year but with a blank as to the end of the taxable year.[xix]

Despite the fact that the Lots were reported as being held as “[i]nventories” on Investment LLC’s 2011 and 2012 tax returns, and notwithstanding CPA’s testimony that, in his opinion, the Lots were always held as inventory, CPA did not file amended Forms 1065 for the LLC as to the pre-2011 taxable years reporting the Lots’ purported status as inventory. Additionally, it was unclear whether CPA had any discussions with Taxpayer regarding the Lots’ reclassification from investment to inventory before filing either the 2011 or the 2012 partnership tax returns.

Personal Returns

Taxpayer’s individual IRS Form 1040 for the 2011 tax year reported income but none of it was attributable to Investment LLC; most arose from Taxpayer’s law practice.

Likewise for the 2012 tax year, Taxpayer’s Form 1040 reported income from the law practice, but none from Investment LLC. This income, however, was offset by a deduction for a business loss that was attributable to the sale of the Lots. The Lots’ price was reported as gross receipts or sales, and Taxpayer’s adjusted bases in the Lots were reported as costs of goods sold.[xx]

Following an examination of Taxpayer’s Form 1040, the IRS determined that Taxpayer was not entitled to the reported business loss because the Lots were capital assets (not inventory) and thus their sale generated a capital (and not an ordinary) loss. The notice of deficiency issued to Taxpayer reflected this determination.

Tax Court

Taxpayer petitioned the Tax Court. The sole issue for decision before the Court was whether Taxpayer’s sale of the Lots resulted in an ordinary loss as reported by Taxpayer, or a capital loss, as the IRS contended.

Both parties agreed that the resolution of the dispute centered around whether the Lots were

“stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

If they were, then their sale resulted in an ordinary loss and not a capital loss.[xxi]

The Court explained that the Code[xxii] differentiates between the “profits and losses arising from the everyday operation of a business on the one hand and the realization of appreciation in value accrued over a substantial period of time on the other hand.”

It explained further that the word “primarily” as used in this context – i.e., property held primarily for sale to customers in the ordinary course – means “of first importance” or “principally.”

Relevant Factors

The Court then enumerated the factors to be considered in making this determination:

(1) the purpose for which the property was acquired;

(2) the purpose for which the property was held;

(3) improvements, and their extent, made to the property by the taxpayer;

(4) the frequency, number, and continuity of sales;

(5) the extent and substantiality of the transaction;

(6) the nature and extent of the taxpayer’s business;

(7) the extent of advertising or lack thereof; and

(8) the listing of the property for sale directly or through a broker.[xxiii]

The Court added, however, that no one factor or group of factors was determinative, and not all factors may be relevant in a particular case, or factors may have varying degrees of relevance depending on the facts of a particular case. Additionally, the Court noted that objective factors carry more weight than a taxpayer’s subjective statements of intent.

Then the Court considered and weighed each of the above factors, in turn, to resolve the issue concerning the character of Taxpayer’s reported loss arising from the sale of the Lots.

The Court began by observing that Taxpayer acquired the Lots via a distribution by Investment LLC as part of an agreement with Partner to deal with the mounting pressure the LLC was facing from Bank as the holder of a deed of trust covering the Lots and Taxpayer’s personal debt exposure. According to the Court, Taxpayer had no intention whatsoever of developing the Lots when he acquired them and thereafter while holding them, and never undertook any development of the Lots during the few months before they were sold; investment was Taxpayer’s principal purpose.

Factors 1 and 2
Furthermore, in point of fact, when the Lots were distributed to Taxpayer, there was no change in purpose. The Court stated it was “very much convinced” that the LLC purchased and held the Lots for investment, the same purpose it had with respect to all of its property. The Court noted that Taxpayer testified that all the things he and Partner did through the LLC were “really investment” and that specifically with respect to the acquisition of the Lots, it was an opportunity to invest in a subdivision that Developer (who was an established developer) was already developing (as the owner of the other five lots in the subdivision). This testimony, the Court observed, was consistent with the representations made on (1) Investment LLC’s tax returns that its principal business activity was “Investment” and (2) the LLC’s annual reports that its business was real estate investment. The tax returns also reported no gross receipts or sales, but sales of real property were reported on the LLC’s 2006, 2007, 2009, 2010, and 2012 Forms 1065 (as well as detailed on attached Schedules D), while no sales whatsoever of real property were reported on the LLC’s 2005, 2008, and 2011 Forms 1065 (and no Schedules D were attached to those forms). Additionally, the agreement between the LLC and Developer, together with Taxpayer’s testimony, showed that Investment LLC had no responsibility at all for developing and marketing the Lots (and did none), while Developer did.

Even assuming that Investment LLC had acquired the Lots for development purposes, all the evidence showed that it abandoned its “development plan” by the end of 2008. At that time, in connection with Investment LLC’s agreeing to dismiss the lawsuit it had filed against Developer, the latter transferred his five lots to the LLC. As of that time, Developer had completed certain development actions; after that time, Developer had no involvement with the subdivision, any of the nine lots, or the LLC, and the LLC did nothing to improve any of the lots or market them for sale. Indeed, the 2011 and 2012 appraisals of the lots by Bank recited that the lots were not listed for sale at the time the appraisals were made.

Factors 1 and 2 weighed against Taxpayer.

Factor 3
Development activities may convert property originally acquired for investment into property held for sale to customers in the ordinary course of business. The only improvements to the Lots were made by Developer, and he made them no later than the end of 2008, when he transferred the Lots to Investment LLC, which was approximately 3½ years before the LLC distributed the Lots to Taxpayer. After that date, no improvements were made to the lots by the LLC and after the LLC distributed the lots to Taxpayer, he never made any improvements to the Lots during the approximate 3½ months that he held them in 2012 before the sale.

Factor 3 weighed against Taxpayer.

Factor 4
On the one hand, other entities of which Taxpayer was an owner developed land lots and sold those lots. On the other hand, as indicated above, from its inception (in 2005) through 2012, the LLC did not report on its IRS Forms 1065 any gross receipts or sales from “inventory”; the only reported sales of any kind were those from the sale of investment properties that resulted in capital gain or loss (and those sales did not include any of the nine lots during the time that the LLC held them). The Court stated that, ultimately, given the facts of the case, Taxpayer’s activity alone should be the focus. To this end, all evidence supported the isolated nature of Taxpayer’s sale of the Lots, rather than an ongoing sole proprietorship engaged in activities related to the sale of real estate.

Factor 4 weighed against Taxpayer.

Factor 5
Taxpayer’s sale of the Lots was the only sale associated with the transaction, and the record was silent as to any continued involvement by Taxpayer with the Lots (e.g., development plans) after selling them. Indeed, when Investment LLC distributed the Lots to Taxpayer, the latter had no intention of developing them. Moreover, and this was significant for the Court, at the time the LLC’s Form 1065 was filed, Taxpayer knew that the fair market values of the Lots were less than the LLC’s investment (bases) in the lots. “Incredibly,” according to the Court, the 2011 Form 1065 was the first return for the LLC on which the Lots were classified as being held for sale. To be sure, Taxpayer continued to experience financial problems in 2012, but such reclassification provided no incentive for him to hold on to the Lots and develop them; the reclassification was Taxpayer’s purported “ticket” to getting a significant ordinary loss through a quick sale of the lots.

Factor 5 weighed against Taxpayer.

Factor 6
Taxpayer’s everyday business was not the development and sale of real estate. For more than three decades before the sale of the Lots, Taxpayer was actively engaged in the practice of law, and his reported income from that endeavor for the period in question was substantial. As relevant here, Taxpayer and his partner formed and operated Investment LLC as a vehicle to invest in real estate and this was borne out in the LLC’s federal and state filings.

Factor 6 weighed against Taxpayer.

Factors 7 and 8
Once Investment LLC distributed the Lots to Taxpayer, he immediately hired Broker to market and sell the Lots. Broker outlined their discussions with Taxpayer regarding the latter’s desire to aggressively market the Lots and bring them to sale. Broker also indicated that she spent substantial time and effort marketing the Lots for sale.

The Court also noted that the fact Broker and not Taxpayer personally marketed and sold the Lots did not per se preclude the Lots from treatment as property held primarily for sale; the activities of brokers are attributable to the taxpayer who hired them.

Factors 7 and 8 weighed in favor of Taxpayer.

On the basis of the foregoing, the Court sustained the IRS’s determination that the loss resulting from Taxpayer’s sale of the Lots was a capital loss.


The Court’s decision was well-founded, as demonstrated by its analysis of the various factors described above.

The frequency and substantiality of sales of property, a taxpayer’s purpose in acquiring the property and the duration of ownership; the purpose for which the property was subsequently held, the extent of developing and improving the property to increase the sales revenue, the use of a business office for the sale of property, the extent to which the taxpayer used advertising or other activities to increase sales, and the time and effort the taxpayer habitually devoted to the sales are important considerations in determining whether property is held for sale in the ordinary course or for investment.  Of these factors, the frequency and substantiality of sales is probably the most important factor.

However, it is also important to recognize that a taxpayer may hold lands primarily for sale to customers in the ordinary course of a trade or business and, at the same time, hold other lands for investment. Stated differently, a taxpayer may play a dual role in holding property for investment purposes as well as primarily for sale to customers in the ordinary course of their trade or business.

It is also possible for a taxpayer’s primary purpose for acquiring and holding a property to change from “for investment” to “for sale,” and vice versa, depending upon changing economic circumstances.

Property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business would generate ordinary income, while the sale of property held by the taxpayer for investment would be accorded capital gain treatment. Thus, the proper characterization of the property in the hands of the taxpayer will have a significant effect upon the economic result realized by the taxpayer on its sale.

The burden of proof, of course, is on the taxpayer to demonstrate their intent with respect to the properties in question. To satisfy that burden, the taxpayer must familiarize themselves with the factors that will be considered by the IRS and by the courts; then, they must be able to support with objective and contemporaneous information in which of the two categories a particular property belongs.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Apologies for the title. I’ve got Hamlet on the brain; thus, the play (pun intended) on Polonius’s fatherly advice (“neither a borrower nor a lender be”), paired with a distraught Hamlet’s contemplation of suicide (“to be or not to be”).

[ii] The figure is comprised of “residential fixed investment” (a measure of home building, multifamily development, remodeling, production of manufactured homes, and brokers; fees) and “housing services” (including gross rents and utilities).

At the end of the fourth quarter of 2021, the housing market’s share of GDP stood at 16.4 percent. In 2020, spending in the housing market represented 17.5 percent of GDP.

[iii] And exacerbated by the pandemic.

[iv] Coupled with a change in priorities attributable to the pandemic.


[vi] The bullish forecast released by Zillow is an exception.,difference%20of%20more%20than%20%2452%2C000.



[ix] The Dallas Fed’s report explains that an “asset – in this case, housing – is in the primary expansionary phase of a bubble when price rises are out of step with market fundamentals. Rapid real house-price appreciation, such as that observed now, does not in itself signal a bubble. Shifts in disposable income, the cost of credit and access to it, supply disruptions, and rising labor and raw construction materials costs are among the economic reasons for sustained real house-price gains.”

[x] “Importantly, experience from the housing bubble in the early 2000s and the subsequent development of advanced tools for early detection and deployment of warning indicators—some illustrated in this analysis—mean that market participants, banks, policymakers and regulators are all better equipped to assess in real time the significance of a housing boom. Thus, they are in a more-informed position to react quickly and avoid the most severe, negative consequences of a housing correction.”


For most homeowners, their homes are a substantial source of their “wealth” and an “increase in housing values encourages homeowners to spend more than they do at other times,” while a “decrease in prices results in the opposite.” Because consumer spending makes up approximately 70 percent of the economy, “changes in household wealth can result in significant changes in economic growth.”

[xii] Musselwhite v. Comm’r, T.C. Memo. 2022-57, Docket No. 14380-16 (Filed June 8, 2022).

[xiii] The first of these, which included members of Taxpayer’s family, purchased 100 acres of undeveloped land, which was divided into approximately 90 lots that were developed with homes in phases. The project lasted 13 years, and all 90 lots were eventually sold. During the development of above-referenced land, Taxpayer and his brother joined another real estate venture that purchased 100 acres of undeveloped land which was developed in phases into a residential subdivision.

[xiv] Separate and apart from Investment LLC, Taxpayer owned portions of several mobile home parks.

[xv] The subdivision consisted of nine undeveloped wooded lots.

[xvi] In other words, no sale of inventory.

[xvii] These gains were also reflected on the Schedules D, Capital Gains and Losses, which were attached to the partnership tax returns.

[xviii] Hindsight is a wonderful thing.

[xix] Reflecting their sale during that year.

[xx] The Lots were treated as “inventory.”

[xxi] See IRC Sec. 1221(a)(1).

The Court stated that whether property is described in IRC Sec. 1221(a)(1) is a factual question, and the burden of proof was on Taxpayer to demonstrate that they held the Lots as described in section 1221(a)(1), and not as a capital asset. Tax Court Rule 142.

[xxii] IRC Sec. 1221(a)(1).

[xxiii] The Court indicated that the U.S. Court of Appeals for the Fourth Circuit was the court to which an appeal of this case would lie. IRC Sec. 7482(b)(1)(A), (2). The Fourth Circuit, the Court stated, has held that these factors were relevant in resolving a Sec. 1221(a)(1) dispute. For that reason, the Court considered the same factors. See Golsen v. Commissioner, 54 T.C. 742, 757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971).