In consolidated cases, the Tax Court has concluded that taxpayers incorrectly characterized ordinary partnership income from the sale of real estate as long-term capital gain. It was determined the properties were held by their partnership primarily for sale to customers in the ordinary course of business and not for investment.
The Facts: Concinnity, LLC (Concinnity), which elected to be taxed as a partnership, was organized by Cordell Pool, Justin Buchanan, and Thomas Kallenbach (taxpayers). These taxpayers also incorporated Elk Grove Development Company (Development).
Concinnity purchased 300 acres of undeveloped land for $1.4 million. At the time of purchase, the land was already divided into four sections (phases 1-4). Concinnity entered into an agreement with Development that gave Development the exclusive right to purchase phases 1-3 (comprising 300 lots) of the land. This agreement required Development to complete all infrastructure improvements to obtain the final plat of each phase of the land. The agreement also outlined more than $5.2 million in construction costs and listed the agreed sale price for the lots subject to the option. Concinnity also entered into an "improvements agreement" with the county agreeing it, as subdivider, would pay for the improvements to the land in phase 1.
In June of 2001, Concinnity filed an affidavit stating it was the developer of the subdivision and that, as of June 13, 2001, it had entered into buy-sell agreements for the sale of 81 phase 1 lots for an average fair market value of $41,000.00 each.
Concinnity also sold land in phases 2 and 3 on February 21, 2003, and reported $500,761 of long-term capital gain on its 2005 tax return, resulting from the taxable portions of two installments it received on the phase 2 and 3 land sales. On their 2005 Forms 1040, the partners reported their shares of the partnership's gain from the sale of real property as long-term capital gain. The IRS claimed that Concinnity's 2003 land sale produced ordinary income. The taxpayers sought relief in the Tax Court, claiming the sale produced capital gain because the land was held for investment.
Generally, preferential treatment is provided regarding gain realized on the sale of a capital asset. Internal Revenue Code Section 1221(a)(1) defines a capital asset as "property held by the taxpayer...but does not include...property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business."
Whether a taxpayer held specified property primarily for sale to customers in the ordinary course of business is a question of fact. The Tax Court and the Court of Appeals for the Ninth Circuit have identified the following factors as relevant to making that determination:
(1) the nature of acquiring the property;
(2) the frequency and continuity of sales over an extended period;
(3) the nature and the extent of the taxpayer's business;
(4) the activity of the seller about the property; and
(5) the extent and substantiality of the transactions.
The property wasn't a capital asset. The Tax Court, reviewing the factors above and finding they all weighed in the IRS's favor, concluded that the proceeds of the land sale should be reported as ordinary income.
Factor #1: Nature of Acquisition
The IRS contended that Concinnity acquired the property to divide and sell lots to customers for profit. Notably, Concinnity's 2000 partnership return identified its principal business activity as "development" and its principal product or service as "real estate," showing that the land was purchased with the intent to develop and sell it. The statements made in the June, 2001 affidavit also supported IRS's position. The Tax Court concluded that the taxpayers failed to show they held the property for investment.
Factor #2: Frequency and Continuity of Sales
The Tax Court observed that frequent and substantial sales of real property more likely indicate sales in the ordinary course of business, whereas infrequent sales for significant profits indicate real property held as an investment. In this case, the record was not clear as to the frequency and substantiality of Concinnity's sales. The Tax Court noted that Concinnity's tax returns reflected two land sales, and its June, 2001 affidavit stated it had entered into buy-sell agreements for the sale of 81 lots in phase 1, with the average sale price suggesting there were customers other than Development. The Tax Court concluded that the taxpayers failed to show their sales weren't frequent and substantial.
Factor #3: Nature and Extent of Business
The IRS argued that the only documents in the record indicated that Concinnity brokered the deals, found additional investors for the development project, secured water and wastewater systems, and guaranteed performance on the improvements agreement. While it did not wholly accept IRS contentions, the Court found there was evidence that Concinnity obligated itself to make certain water and wastewater improvements to the land and paid for those improvements. The Tax Court reasoned this level of activity was more akin to a real estate developer's involvement in a development project than to an investor's increasing the value of his holdings. Further, the Tax Court noted that, on the facts, there was no need for Concinnity to construct the water and wastewater systems to promote sales and attracting buyers because the taxpayers owned Development-the company granted the exclusive right to purchase the land. The Tax Court concluded that the taxpayers failed to demonstrate that Concinnity's development activities could not show it held the land primarily for sale in the ordinary course of its trade or business.
Factor #4: Activity of Seller About the Property
The record was unclear whether Concinnity sought the 81 individual purchasers it accumulated by June 13, 2001, whether the purchasers sought Concinnity, or whether Concinnity sold only to Development. The Tax Court found that the taxpayers failed to show that Concinnity did not spend large portions of its time actively participating in the sales of the land. The Tax Court said this factor weighed in favor of IRS.
Factor #5: Extent and Substantiality of the Transaction
While the IRS argued that Development should be ignored as an entity because the taxpayers incorporated it principally to evade tax, the Court found that the "identical ownership" of Concinnity and Development didn't necessarily mean that Development should be disregarded. Under the land exclusive option agreement, Development had the option to buy only phases 1 - 3 of Elk Grove PUD while Concinnity retained phase 4. Under that agreement, Concinnity sold only those three phases to Development, and the Court determined that maintaining phase 4 in a separate entity -- sheltered from any potential action arising from Development's activity -- constituted a valid business purpose for Development's existence. However, the Court concluded that the taxpayers failed to produce sufficient evidence demonstrating they engaged in a bona fide, arm's-length transaction.
For these reasons, the Court ruled in favor of the IRS and determined the gain on the sale of land to be ordinary in character.
Tax Warrior Perspective
While land is usually thought of as a capital asset, this case highlights the need for sellers to accurately determine whether their land was held primarily for investment or development purposes. The Tax Warriors® at Drucker & Scaccetti have extensive experience with real estate transactions and can assist in determining the proper character of gain that results from property sales. Our highly trained experts can also help you structure transactions in the most tax-efficient manner. Contact us via the “Ask A Tax Warrior” button below if you have questions about your specific situation. We are always prepared to help you with this or any other tax and business consulting matter related to real estate ownership and development.
Topics: real estate, Land Sale, Real Estate Sale, Land, Real Estate Development, Developer, Ordinary Income, Capital Gain, Section1221, Capital Asset, Ordinary Income vs Capital Gain, Ordinary Course of Business