Ordinary Income v. Capital Gains on Selling Foreclosed Property

WENDELL V. AND SHARON T. GARRISON v. COMMISSIONER

U.S. TAX COURT

December 1, 2010

Facts: Wendell Garrison, in the years under question, 1998 to 2000, was a Mortgage Broker making about $40,000 a year from his mortgage business. Also during this time period he and his wife bought and sold foreclosed properties, flipping them as quickly as possible, holding them for a period averaging about four months. The Garrisons reported the income from the properties as capital gains rather than ordinary income. The IRS claimed that the properties were not bought as longer-term investments, but were merely inventory in the ongoing business of buying and quickly reselling foreclosed houses. The IRS sent a notice of deficiency stating that since this was ordinary income, self-employment taxes were also due against the earnings. The Garrisons appealed the ruling to the Tax Court

Analysis and Conclusion: Prior Court rulings have outlined the criteria for whether the buying and selling of property should be considered capital gains or ordinary income (see box below). Since the Court saw the Garrisons as buying and selling homes on an ongoing basis, rather than investing in them for the longer term, the Court considered their activities to be a Schedule C business earning ordinary business income. Therefore, they had to pay employment taxes on their selfemployment income. The ruling was in favor of the IRS.

Notes: This is a particularly timely case with the vast amount of foreclosures currently on the market. No doubt, if one of your clients dabbles in the business of buying and selling foreclosed properties, they need to understand that their activities can be considered a side business earning ordinary income.

Source: National Society of Tax Professionals: Federal Tax Alert, December 2010