The Iowa Capital Gain Deduction - Learning How To Count Properly Can Save Taxes (and Interest and Lawyer Fees)

September 14, 2015 | Roger A. McEowen

Lance v. Iowa State Board of Tax Review, No. 14-1144, 2015 Iowa App. LEXIS 814 (Iowa Ct. App. Sept. 10, 2015)

Overview

Iowa tax law provides for a 100 percent deduction for qualifying capital gains.  The most basic of the qualifying elements for the deduction requires the ability to count to 10 – or five, once retirement occurs.  However, counting to 10 (or five) apparently is not easy for some taxpayers (and their legal counsel). 

Iowa Capital Gains Deduction

Capital gains that qualify for the deduction result from the sale of real estate that is used in a trade or business in which the taxpayer materially participated for 10 years immediately before the sale and which has been held for at least 10 years immediately bore the sale.  In addition, a capital gain that qualifies for the deduction results from the sale of a business in which the taxpayer materially participated for the 10 year period immediately preceding the sale, and which had been held for at least 10 years immediately before the sale.  When a business is sold, the capital gain deduction applies when the sale is of all or substantially all (e.g., 90 percent of the fair market value or more) or the tangible personal property or service of the business (including some intangible personal property). 

The material participation requirement is tied to the passive loss rules of I.R.C. §469. Under those rules (Treas. Reg. §1.469-5T(a)) seven tests are set forth for meeting the material participation test (only one of which needs to me satisfied:

  • The taxpayer participated in the activity for more than 500 hours during the year;
  • The taxpayer participated in the activity for more than 100 hours during the year, and the taxpayer’s participation is not less than the participation of any other individual;
  • The taxpayer participated in the activity for more than 100 hours during the year, and no one else participated more;
  • The taxpayer participated in a significant participation activity for at least 100 hours, and the taxpayer’s aggregate participation in all significant participation activities for the year exceeds 500 hours;
  • The taxpayer materially participated in the activity for any five year period during the 10 years immediately preceding the year of the sale;
  • The activity is a personal service activity and the taxpayer materially participated in the activity for any three taxable years, whether or not consecutive, preceding the year of the sale; and
  • Based on all of the facts and circumstances, the individual participates in the activity on a basis that is regular, continuous and substantial during the year.

A couple of basic points on material participation are worth mentioning.First, participation as an investor – studying and reviewing financial statements or reports on operations of the activity, compiling data of operations, etc., don’t count as material participation.That’s not participation in the daily management of the business.Second, upon retirement, a taxpayer’s material participation doesn’t simply stop when retirement begins.That’s where the five-out-of ten year test noted above kicks in.This is the rule for non-farmers.[1]The taxpayer is considered to have satisfied the material participation test if they materially participated for at least five of the last ten years before the sale.So, as stated above the ability to count is crucial.A taxpayer has five years to sell the business after retiring to qualify for the Iowa capital gain deduction.

Facts of the Case

The taxpayers (a married couple) purchased a rooming house that they used as a rental property.For 13 years, they managed all aspects of the rental business.Then, in 1994, they contracted with a third party to manage the property.A management agreement was executed in 1998 with the third party which assigned the management role to the third party as the “owner’s exclusive agent to manage, rent, lease and operate the property.”In 2005, the taxpayers sold the rental property and claimed the 100 percent capital gain deduction on their Iowa return.The Iowa Department of Revenue (IDOR) disallowed the gain for the taxpayers’ failure to satisfy the 10-year material participation test, and assessed $40,742.33 in tax, penalties and interest.The taxpayers protested the IDOR’s position, claiming that the IDOR’s regulatory position (contained in I.A.C. 701-40.38(1)) that material participation was required during the 10-year period preceding the sale didn’t track the statute (Iowa Code §422.7(21)(a)(1)).They claimed that once they had participated for a total of ten years, no matter when that participation occurred, the Iowa capital gain deduction was available.In any event, the taxpayers also claimed that they did materially participate for the ten years immediately preceding the sale.

An administrative law judge (ALJ) ruled for the taxpayers because the ALJ believed that the taxpayers had put more than 100 hours into the activity every year, and no one else’s participation exceeded that amount.The ALJ did not rule on the statutory argument.

The IDOR appealed (to itself) and the IDOR Director reversed the ALJ.The IDOR noted that Iowa Code §422.7(21)(a)(1) tracks the regulations under I.R.C. §469, as noted above, and that those regulations clearly require material participation for at least five of the ten years immediately preceding the sale.The taxpayers ceased materially participating in 1994 and sold the property in 2005, and weren’t even close to satisfying the five-out-of ten year test.The IDOR also noted that the taxpayers had failed to substantiate material participation for any of the years in question because they didn’t maintain contemporaneous documentation of actual or estimated hours, and had changed their after-the-fact estimates multiple times.

The taxpayers appealed to the State Board of Tax Review which affirmed IDOR’s determination, holding that the taxpayers failed to establish the necessary material participation of Iowa Code §422.7(21)(a)(1).Undaunted, the taxpayers sought judicial review.

The trial court affirmed on the basis that Iowa Code §422.7(21)(a)(1) clearly required material participation for 10 years before the sale and that the IDOR had the authority to interpret the statute, and that the IDOR interpreted the statue in a rational manner.The trial court also determined that the taxpayers had failed to substantiate material participation.Again, the taxpayers appealed.

The Iowa Court of Appeals affirmed.The taxpayers, probably realizing that their statutory arguments were wholly without merit, claimed that the IDOR’s regulatory interpretation of the statute was not entitled to deference.However, the court easily dismissed this argument by noting that the legislature had given the IDOR the authority to interpret the statute and that IDOR’s interpretation would be upheld unless it was “irrational, illogical or wholly unjustifiable.”It wasn’t.There simply was nothing in the statute (or elsewhere in the Iowa Code) that was contrary to the IDOR’s interpretation.The court also noted that the IDOR’s interpretation squared with I.R.C. §469 and the regulations thereunder where the five-out-of ten year test is located. The court also noted that the IDOR regulation at issue had been around for 25 years with no legislative change.

The court also held that the taxpayers had failed to establish material participation based on the evidence (or lack thereof).The management agreement with the third party was the killer.Under that agreement, they clearly transferred management responsibilities away.What they were left with were investor-type activities that don’t count as material participation.

Conclusion

Counting is important when it comes to the Iowa capital gain deduction.In this case, the capital gain deduction would have been available if the taxpayers had sold the business within five years of retiring – executing the management agreement.

Will the taxpayers petition the Iowa Supreme Court to hear the case? Who knows? They seem to have a bottomless pit when it comes to paying legal fees to appeal a case in which they have little to no chance of prevailing.But, the Iowa Supreme Court (based on a case several years ago) thinks that it knows tax better than the U.S. Supreme Court, so it’s a roll of the dice what result would be obtained there.

 

 

 

 

 

[1] Farmers who materially participate in five of the last eight years before they start drawing Social Security benefits are considered to materially participate in the farming activity in perpetuity.