Capital loss vs. ordinary loss.

When taxpayers realize losses, they generally prefer to classify them as ordinary business losses rather than capital losses. In the case of the financial misadventures of Richard L. Matz, this was not to be.

Matz claimed ordinary business losses and interest deductions totaling over $4 million for failed start-up companies and real estate ventures. The IRS denied the business deductions and determined instead that he underpaid his taxes by approximately $900,000 (Richard L. Matz, et ux. v. Commissioner, TC Memo 1998-334).

Matz was primarily a real estate broker, but he also invested in real estate, from which he reported losses of several million dollars. He had bought and sold 45 real estate properties over a period of three decades. Matz claimed that he was in the business of acquiring, developing and selling real estate for profit and that he held the real estate for sale to customers in the ordinary course of business. This reasoning would support the classification of his current real estate losses as ordinary business losses rather than capital losses.

The Tax Court, however, disagreed. It determined that the sales were not frequent and substantial enough to qualify the activity as a trade or business. Accordingly, the court deemed Matz's real estate losses capital losses.

In its decision, the court listed seven factors that determine whether a sale of land is considered to be a sale of a capital asset or a sale of property held primarily for sale to customers in the ordinary course of business. The frequency and substantiality of sales are the most important factors. No precise number of sales is needed to be in a trade or business, and one court held that a single real estate transaction could qualify an activity as a trade or business.

Matz also invested in six start-up businesses, including a commuter airline, from the 1960s through the late 1980s. He asked for a refund of his investment in the airline stock and received a $325,000 note, which became worthless. He deducted the loss as an ordinary loss under IRC section 165(a) and (c)(1) and as a business bad debt under IRC section 166(a). He claimed he was in the business of promoting, developing, organizing and financing start-up businesses.

To be engaged in a trade or business, an individual must be involved in an activity with continuity and regularity and for the primary purpose of earning income or profit. The Tax Court determined that Matz's business development activity was sporadic and not a regular trade or business that would generate an ordinary loss under section 165(c)(1). The loss was a nonbusiness bad debt treated as a capital loss under section 166(d) rather than a fully deductible business bad debt under section 166(a).

Observation: When an entrepreneur or real estate developer seeks to deduct a loss from a small business or a real estate venture, it is critically important to have documentation that supports classifying the activity as a trade or business.

--Howard Godfrey, CPA, PhD, professor of accounting, University of North Carolina at Charlotte.