Document Number
95-157
Tax Type
Individual Income Tax
Description
Taxes paid to other states; Capital gain from sale of subdivided property
Topic
Credits
Date Issued
06-16-1995
June 16, 1995




Re: §58.1-1821 Application: Individual Income Tax


Dear**********

This will reply to your letter of March 9, 1995, in which you protest the disallowance of an out-of-state tax credit claimed by your client,*************(the "Taxpayer") for the 1992 taxable year.
FACTS


The Taxpayer is a Virginia resident, and was a co-owner of unimproved real estate outside of Virginia which was acquired in 1975. The property was subsequently developed and subdivided into lots. In 1992, two of the Taxpayer's lots were sold resulting in net gains on which the Taxpayer paid tax to another state. The Taxpayer claimed an out-of-state tax credit on the 1992 Virginia individual income tax return for the taxes paid to the other state. The credit was disallowed by the department and additional tax was assessed. The Taxpayer asserts that the sale of the lots constitutes business income and that the tax credit should be allowed.
DETERMINATION


Code of Virginia §58.1-332 (A) provides individuals a credit for income tax paid to another state:
    • Whenever a Virginia resident has become liable to another state for income tax on any earned or business income for the taxable year...(Emphasis added)

The department's basis for disallowing the credit claimed by the Taxpayer (for taxes paid to another state) is that the capital gain derived from the sale of real estate did not constitute business income. You state that under Internal Revenue Code (IRC) §1237, the activity of subdividing a tract of land into more than 5 lots is a business activity, and therefore the capital gains derived from the subsequent sale should be business income for purposes of the out-of-state tax credit.

IRC §1237 enables an individual to subdivide real estate for quicker sale, and receive capital asset treatment on the sales. Individuals qualifying under IRC §1237 can sell real estate from a single tract held for investment without having the gain taxed as ordinary income, even though they subdivide the tract and engage in normal selling activities. This relief provision doesn't apply to real estate dealers.

To qualify under IRC §1237, the individual must show that:
    • 1. He hasn't previously held the tract (or any parcel thereof), for sale to) customers in the ordinary course of business.

      2. In the year of sale, he didn't hold any other real estate for sale to customers in the ordinary course of business.

      3. He has held the property for 5 years.

      4. No substantial improvements were made by him that substantially enhanced the value of the lot or parcel sold while he held the property.

      5. No substantial improvements enhancing the value of the lot or parcel sold were made by the taxpayer or buyer under a contract of sale.
Virginia Regulation (VR) 630-2-332, §2 defines business income as:
    • For purposes of this credit, the term "business income" shall mean income from an activity which constitutes a "business" for federal income tax purposes for which a federal Schedule C, E, or F must be filed...
This implies that a person must be engaged in a continuous and regular course of business, and not irregular or isolated transactions. Although the Taxpayer reported the income under IRC §1237, the department does not find that the income constitutes trade or business income. Generally, the subdivision of real estate leads to ordinary income treatment for federal tax purposes. IRC 1237 provides an exception whereby individuals that are not regularly engaged in development activities may receive capital gain treatment even though the real property has been subdivided. The fact that the transactions qualified under IRC §1237 is a strong indication that the Taxpayer was acting as an investor, as opposed to engaging in a trade or business activity on a regular and continuous basis.

In addition, the main implication of IRC §1237 is the determination of whether income is taxed as ordinary income or capital gain. This determination has little bearing on Virginia for purposes of determining whether income arises from a trade or business. For example, the sale of rental property may be taxed as capital gain under IRC §1231, but would be considered business income for Virginia purposes. The receipt of interest or dividends is taxed as ordinary income for federal income tax purposes, but is not considered business income for Virginia purposes. The treatment accorded for purposes of the Virginia tax credit is dependent on the facts and circumstances surrounding the asset, and not necessarily on the federal tax treatment.

Accordingly, the assessment must be upheld. The remaining balance of the assessment,**********as shown on the attached schedule, should be paid within 30 days to avoid the accrual of additional interest. Please forward your payment to the Office of Tax Policy, Virginia Department of Taxation, P.O. Box 1880, Richmond, Virginia 23282. Should you have additional questions regarding this matter, please contact*********.
                        • Sincerely,



                          Danny M. Payne
                          Tax Commissioner


OTP/9450P

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46