McManus v. Commissioner: When Real Estate Gains Are Ordinary Income, Not Capital Gain

McManus v. Commissioner, 65 T.C. 197 (1975), aff'd, 583 F.2d 443 (9th Cir. 1978) is one of the most frequently cited cases in real estate taxation. It draws the critical line between a real estate investor — whose gains qualify for favorable capital gain treatment — and a real estate dealer — whose gains are taxed as ordinary income.

The difference in tax rates can be substantial. Getting this wrong is one of the most expensive mistakes a real estate operator can make.

IRC §1221 defines a capital asset as property held by the taxpayer — except property held primarily for sale to customers in the ordinary course of a trade or business.

That exception is where real estate disputes live.

The Tax Court in McManus framed the issue precisely:

This distinction is fundamental because:

• Investors earn profits from appreciation in the value of capital assets
• Dealers earn profits from the ordinary operations of buying, developing, marketing, and selling property

The purpose of IRC §1221 is to distinguish between these two very different sources of gain.

Many taxpayers mistakenly believe that a profit motive determines whether they are in business.

It does not.

Virtually every investor purchases property hoping to sell it later for more than they paid. The court in McManus was explicit on this point: simply intending to make a profit is not enough. Investors also intend to make profits.

The critical question is how the profit is earned.

The court did not ask whether the taxpayers wanted a profit. It asked:

If the profit comes from business operations — development, subdivision, marketing, repeated sales — the gain is ordinary income.

If the profit comes from passive appreciation of an investment, the gain is capital gain.

The taxpayers in McManus acquired a prime industrial tract and managed it with the expectation of eventually selling it at a profit. The court looked at the totality of the circumstances and found the following facts decisive.

Rather than holding raw land passively, the taxpayers:

• Subdivided the tract
• Installed streets
• Installed utilities
• Prepared lots for sale

These activities added value through active development rather than passive ownership. The court viewed them as classic business activity — the kind of work a professional land developer performs, not a passive investor.

The taxpayers did not dispose of the property in a single isolated transaction. They sold numerous parcels over several years as opportunities arose.

Repeated, continuous sales are a hallmark of operating a business rather than liquidating an investment. One or two sales of appreciated land can look like investment activity. A pattern of sales to multiple customers over multiple years looks like a business.

The improvements were not undertaken merely to preserve the property's value. They were undertaken to make the lots marketable and maximize sales proceeds. That is exactly what a land developer does — creating inventory for customers rather than simply holding an appreciated asset.

The statute focuses on property held primarily for sale to customers. The court emphasized that the partnership was creating and selling finished inventory to customers — not disposing of a long-held investment.

The Tax Court effectively asked two questions:

Was the taxpayer making money because the land appreciated?

or

Was the taxpayer making money because they were developing and marketing real estate?

The answer was the latter. Their profit resulted from development, subdivision, marketing, multiple sales, and entrepreneurial activity. That made them real estate dealers — and their gains ordinary income.

The phrase "ordinary course of business" does not require:

• Employees
• An office
• A business license
• Incorporation
• Full-time activity

Instead, it asks whether the taxpayer is regularly engaged in activities that resemble those of someone in that line of business. In McManus, the taxpayers were functioning like professional land developers — even though they were also involved in construction businesses. The court looked at what they were actually doing, not how they described themselves.

McManus relies heavily on the Supreme Court's decision in Malat v. Riddell, 383 U.S. 569 (1966).

Malat held that "primarily" in the §1221 exclusion means "of first importance" or "principally." Courts therefore determine the taxpayer's principal purpose for holding the property at the time of sale — not merely the purpose when the property was originally acquired.

McManus applied this principle directly: even if the taxpayers initially had investment motives when they acquired the tract, by the years in question their principal purpose had become selling developed lots to customers. The original intent was irrelevant. What mattered was the purpose at the time of the sales.

This is a critical planning point. A property acquired as an investment can become dealer property over time if the owner's activities shift toward development and repeated sales.

Some parcels in McManus were sold because of actual or threatened condemnation. The taxpayers argued these should receive capital gain treatment because they were no longer voluntarily held for sale to customers.

The court disagreed. Condemnation did not change the underlying character of the property. The parcels remained part of the inventory of the taxpayers' land development business — so the gains were still ordinary income.

This holding has significant implications. Once property is characterized as dealer inventory, even an involuntary disposition may not rescue capital gain treatment.

McManus is frequently cited for the multi-factor analysis courts apply when evaluating whether real estate activities constitute a trade or business. No single factor controls — courts consider all the facts and circumstances.

McManus reinforces a principle that continues to govern real estate taxation today: a taxpayer's profit motive alone does not determine whether an activity is a trade or business.

The decisive issue is whether the taxpayer's profit arises from ordinary business operations — development, subdivision, and repeated sales — or from the passive appreciation of a capital investment. That distinction determines whether gains are taxed at preferential capital gain rates or as ordinary income under IRC §1221.

For real estate operators, the stakes are high. Long-term capital gain rates currently top out at 20% for high-income taxpayers. Ordinary income rates reach 37%. On a $1 million gain, the difference is potentially $170,000 or more in additional federal tax — before state income tax.

Understanding McManus is not just academic. It has direct planning consequences for anyone who buys, develops, and sells real estate.

Separate investment and dealer activities. Many real estate operators hold some properties as long-term investments and actively develop and sell others. Keeping these activities in separate entities — with separate books, separate financing, and separate decision-making — helps establish that investment properties are genuinely held for appreciation, not as inventory.

Document investment intent contemporaneously. Board minutes, partnership resolutions, and internal communications that reflect a long-term investment purpose at the time of acquisition are valuable evidence if the IRS later challenges capital gain treatment.

Be cautious about improvements. Extensive subdivision, infrastructure installation, and lot preparation are the exact activities that converted the McManus taxpayers from investors to dealers. Passive investors generally do not subdivide and install utilities.

Monitor sales frequency. A pattern of repeated sales to multiple customers over multiple years is one of the strongest indicators of dealer status. If you find yourself selling parcels regularly, the IRS may characterize the activity as a business regardless of your intent.

Condemnation is not a safe harbor. As McManus makes clear, an involuntary sale does not automatically convert dealer inventory into a capital asset. If the property was already dealer property, the gain is ordinary income even if the sale was forced.

At Autarky Tax & Accounting, our team includes former US Treasury and IRS agents who understand how the IRS evaluates dealer vs. investor status — and how to structure real estate activities to support the most favorable tax treatment. Whether you are planning an acquisition, structuring a development project, or responding to an IRS inquiry, the characterization of your gains matters enormously.

Schedule a free consultation to discuss your real estate activities and how to protect your capital gain treatment.

This article is intended for educational purposes and should not be relied upon as legal or tax advice. Every taxpayer's situation is unique and should be evaluated individually.