According to a recent decision by the tax court (Sutton TC 2013-6) a loss on abandonment of an option to purchase real estate is treated as an ordinary loss not a capital loss.
A taxpayer acquired an option to buy real estate and after failing to attract sufficient funding to acquire and develop the property abandoned the option and reported a loss of $48,000.
Real Estate Tax Treatment Options
As is common with many real estate developers in California and Coachella Valley specifically, real estate investors often acquire options to purchase a parcel with intent to develop. Assuming the land is subdivided and developed and is later sold at a profit on a regular basis over a period, generally any income is treated as ordinary income. Income is ordinary because the developer is presumably in the business of developing real estate. An alternative strategy is that applicable to resellers, or “flippers” of properties where one is not actively involved in managing or developing the property. The latter treatment would result in capital gain/loss reporting subject to capital gain rates – in the case of individuals – and also subject to capital loss limitations and passive loss limitations – again applicable to individuals. Applying these to the case in point, the taxpayer’s $48,000 loss would have been limited to $3,000 per year if it were deemed a capital loss whereas the entire $48,000 loss would be deductible if it were an ordinary loss.
Issue and Decision
At issue was whether the loss on abandonment of the option was a capital loss – as the taxpayer claimed, or an ordinary loss – as the IRS argued. As per Section 1234, the character of gain or loss is determined by the property it attaches to. In other words, it the gain or loss on the sale of the property underlying the option were capital or ordinary, the gain or loss on the option would be treated respectively as capital or ordinary. The court determined that because the taxpayer would have to report any future income associated with the property to be developed as ordinary income from his development activities, the loss on abandonment of the option is also an ordinary loss. Therefore the taxpayer can deduct the entire loss in the tax year of disposition of the option.
Thus, the taxpayer benefits from the ordinary loss treatment. However, it the opposite were true and the taxpayer realized a gain on disposition of the option; the gain would be taxed at his ordinary income tax rates which are generally higher than capital gain rates.
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