In Cordell D. Pool, et al. v. Commissioner, TC Memo 2014-3, real estate investors made some obvious mistakes in structuring the sale and ultimate development of real property and, as a result, incurred ordinary income tax upon the disposition of the real estate instead of preferential capital gains treatment. This case illustrates measures that should be taken by investors to position themselves to support preferential tax treatment on the sale of investment property.
The facts of the case present a typical transaction structure. Concinnity, LLC (the “Investment LLC”), was organized in the State of Montana in March 2000 by a group of individuals (the “Taxpayers”). The Taxpayers also incorporated and became the shareholders of Elk Grove Development Co. (the “Development Corporation”) in August 2000.
Investment LLC purchased 300 undeveloped acres for $1.4 million on June 27, 2000, with a closing date of July 5, 2000. At the time of purchase, the land was already divided into four sections–referred to as phases 1-4. This property later became the Elk Grove Planned Unit Development (the “PUD”).
Investment LLC entered into an agreement with Development Corporation that awarded Development Corporation with the exclusive right to purchase phases 1-3 (consisting of 300 lots) of PUD and required Development Corporation to complete all infrastructure improvements necessary to obtain the final plat of each phase of PUD. Investment LLC also entered into a development agreement with the applicable municipality whereby Investment LLC agreed that it, as subdivider, “shall, at its sole cost and expense, pay for the improvements” to the land in phase 1. In order to secure municipal approval, Investment LLC also filed an affidavit whereby it affirmed that it was the developer of the proposed PUD subdivision and that as of June 13, 2001, Investment LLC entered into buy-sell agreements for the sale of 81 lots within phase 1 of PUD for an average fair market value of $41,000.00 per lot.
Investment LLC reported on its Federal income tax returns that it sold land in phase 1 on May 31, 2001, and phases 2 and 3 on February 21, 2003 and reported $500,761 of long-term capital gain on its 2005 Schedule D, Capital Gains and Losses. This gain resulted from the taxable portions of two installments it received on the phase 2 and 3 land sales.
The IRS determined deficiencies for the Taxpayers’ 2005 federal taxes. It contended that Investment LLC’s 2003 land sale produced ordinary income and not preferential capital gains. Specifically, the IRS argued that pursuant to Section 1221(a) (1), a “capital asset” does not include “property held by the taxpayer primarily for sale to customers in the ordinary course of business.”
Whether a taxpayer holds property primarily for sale to customers in the ordinary course of business is a question of fact which is resolved based on an evaluation of the following factors:
- The nature of the acquisition of the property;
- The frequency and continuity of sales over an extended period of time;
- The nature and extent of taxpayer’s business;
- The activity of seller about the property; and
- The extent and substantiality of the transactions.
Transaction Structure had a Legitimate Business Purpose
It is important to note that the transaction structure itself was not inherently flawed. The IRS argued that the court should disregard Development Corporation as an entity because it was incorporated principally to evade Federal income tax. This argument was supported by noting the identical ownership of Investment LLC and Development Corporation.
The IRS rejected this argument explaining that Development Corporation had an option to purchase phases 1-3 but that Investment LLC retained phase 4 and that isolation of phase 4 in a separate entity sheltered it from any potential claims associated with Development Corporation’s activities developing PUD.
Taxpayer Unforced Errors
The factual records included unnecessary and detrimental statements informing the IRS and court analysis. Investment LLC identified its principal business activity as “development” on its Form 1065. The company also filed the above described affidavit affirming that it was the developer of the PUD and had secured agreements for the sale of 81 lots.
The IRS also persuasively argued that the transactions between Investment LLC and Development Corporation were not arm’s length. The applicable agreement provided that the sale price for all 300 lots was approximately $7.6 million. This agreement had an effective date of July 7, 2000. Just two days before this agreement was signed, Investment LLC purchased all four phases for $1.4 million. The court believed the circumstances strongly suggest that Taxpayers chose the price to convert a large portion of the project’s final profits to capital gain.
Recommendations to Enhance Capital Gain Position
The Taxpayers made some clear errors with adverse tax consequences. The following actions may produce a better position to support a capital gain characterization of a similar transaction structure:
- The sale price should be supported by an appraisal and the terms of the sale should reflect an arm’s length transaction.
- Organizational documents of each of the selling and purchasing entities should reflect the appropriate investment or development intent.
- The seller and purchaser must be separate and distinct entities with separate books, records and bank accounts.
- Investors should form a new legal entity for each new real estate project.
- The purchaser should realize a profit (or have a realistic opportunity to realize a profit) upon its ultimate disposition of developed property.
- In the case of an installment sale, the purchaser should have sufficient equity capitalization to establish its ability to repay the note.
- The purchaser should make timely payments under the note and the seller should pursue any remedies in the case of a payment default.
- The purchaser should not undertake improvements, repairs or pre-sale activities until title is acquired.