Real estate developer's sale of land was taxed as capital gain and not as ordinary income

Sugar Land Ranch Development, LLC, TC Memo 2018-21

The Tax Court has held that a partnership was not engaged in a development business after 2008 and so held the real estate properties at issue as investments. Accordingly, the Court found that the taxpayer properly characterized the gains and losses from the sales of the properties as income from capital assets, rejecting IRS's recharacterization as ordinary income.

Background. Under Code Sec. 1221(a)(1), a capital asset is "property held by the taxpayer (whether or not connected with his trade or business)" but excludes, among other things, "inventory" and "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business."

The Fifth Circuit (the court to which this case would be appealable) held that the three principal questions to be considered in deciding whether gain is capital in character are: (1) Was taxpayer engaged in a trade or business, and, if so, what business? (2) Was the taxpayer holding the property primarily for sale in that business? and (3) Were the sales contemplated by taxpayer ordinary in the course of that business? (Suburban Realty Co v. U.S., (CA 5 1980) 45 AFTR 2d 80-1263)

The Fifth Circuit may consider a number of factors in this inquiry:

• the frequency and substantiality of sales of property;
• the taxpayer's purpose in acquiring the property and the duration of ownership;
• the purpose for which the property was subsequently held;
• the extent of developing and improving the property to increase the sales revenue;
• the use of a business office for the sale of property;
• the extent to which the taxpayer used advertising, promotion, or other activities to increase sales; and
• the time and effort the taxpayer habitually devoted to the sales.

Of these factors, frequency and substantiality of sales is the most important factor. (Suburban Realty)

Facts. Sugar Land Ranch Development, LLC (SLRD) was established as a limited liability company (LLC) taxable as a partnership in '98. It was formed principally to acquire contiguous tracts of land in Sugar Land, Texas, just southwest of Houston, and to develop that land into single family residential building lots and commercial tracts.

In '98, it purchased property that had formerly been an oil field, which was being developed by parties related to SLRD. Its original plan was to clean up the property and subdivide it into residential units. To that end, between '98 and 2008 SLRD capped oil wells, removed oil gathering lines, did some environmental cleanup, built a levee, and entered into a development agreement with the City of Sugar Land, which specified the rules that would apply to the property, should it be developed. SLRD sold or otherwise disposed of relatively small portions of the property between '98 and 2008.

Late in 2008, Larry Johnson and Lawrence Wong, the managers of SLRD, decided that SLRD would not attempt to subdivide or otherwise develop the remaining property it held, which included the parcels TM-1, TM-2, and TM-3 (collectively, the TM parcels). From their long experience in the real estate development business, they believed that SLRD would be unable to develop, subdivide, and sell residential and commercial lots from the property because of the effects of the subprime mortgage crisis on the local housing market and the scarcity or unavailability of financing for housing projects in the wake of the financial crisis. Instead, they decided that SLRD would hold the property as an investment until the market recovered enough to sell it off. These decisions were memorialized in a "Unanimous Consent" document dated Dec. 16, 2008 (signed by Johnson and Wong), as well as in an SLRD member resolution adopted on Nov. 19, 2009, to further clarify SLRD's policy.

Between 2008 and 2012 the TM parcels "just sat there" (as Johnson credibly testified). SLRD did not develop those parcels in any way. SLRD did not list the TM parcels with any brokers or otherwise market the parcels because SLRD's managers believed that there was no market for large tracts of land on account of the subprime mortgage crisis. However, in 2011, Taylor Morrison approached SLRD about buying TM-1 and TM-3.

In 2011, Taylor Morrison purchased TM-1. In 2012, SLRD sold TM-2 and TM-3 to Taylor Morrison under contracts which called for him to pay a lump sum to SLRD in 2012 for the largely undeveloped parcels. The TM-2 contract also provided that Taylor Morrison was obligated to pay SLRD 2% of the final sale price of each future home eventually developed and sold out of TM-2. The TM-2 contract specified that each 2% payment would accrue when each home sale closed. SLRD was also to receive $3,500 for each plat recorded on TM-2. Unlike the TM-2 contract, the TM-3 contract did not provide for a 2% per-home payment, but did provide for a payment of $2,000 for each plat recorded on TM-3. The TM-2 and TM-3 contracts also listed other development obligations for which the parties (mostly Taylor Morrison) were responsible.

No part of the payments received by SLRD from Taylor Morrison in 2012 included either the 2% per-home or per-plat fees provided for in the TM-2 and TM-3 contracts. That is, the net gain at issue in this case represents only the lump sum payments SLRD received in 2012.

After beginning the sale of the TM parcels, SLRD decided to close out its property holdings by conveying the remainder of its property (generally to related parties).

The issue. The sole issue presented for the Court's consideration was whether SLRD's sales of the TM-2 and TM-3 parcels was to be treated as giving rise to capital gains or ordinary income.

Court's conclusion. Because the TM parcels were held for investment and were not sold as part of the ordinary course of SLRD's business, the Tax Court held that net gains from the sales of TM-2 and TM-3 were capital in character.

The evidence clearly showed that in 2008 SLRD ceased to hold its property primarily for sale in that business and began to hold it only for investment. SLRD's partners decided not to develop the property any further, and they decided not to sell lots from those parcels. This conclusion was supported by the highly credible testimony of Johnson and Wong and by the 2008 unanimous consent and the 2009 member resolution.

In fact, from 2008 on, SLRD did not develop or sell lots from those parcels (and the evidence did not suggest that SLRD ever sold even a single residential or commercial lot to a customer at any point in its existence). IRS conceded that SLRD never subdivided the property. More particularly, when the TM parcels were sold, they were not sold in the ordinary course of SLRD's business: SLRD did not market the parcels by advertising or other promotional activities. SLRD did not solicit purchasers for the TM parcels, nor did any evidence suggest that SLRD's managers or members devoted any time or effort to selling the property—rather, Taylor Morrison approached SLRD. Most importantly, sale of the TM parcels was essentially a bulk sale of a single, large, and contiguous tract of land (which was clearly separated from any other properties by a particular easement and the levee) to a single seller which was clearly not a frequent occurrence in SLRD's ordinary business.

The Tax Court was not convinced by IRS's argument that the extent of development of the TM parcels showed that the properties were held primarily for sale in the ordinary course of SLRD's business. It was clear that from '98 to sometime before 2008, SLRD developed the property to a certain extent. But it was also clear that in 2008 SLRD's managers decided not to develop those parcels into a subdivision and decided not to market the land as it ordinarily would have. Citing Suburban Realty, the Tax Court stated that a taxpayer was entitled to show that its primary purpose changed to, or back to, an investment purpose. SLRD made such a showing. The Court found that any development activity that occurred before the marked change in purpose in 2008 was largely irrelevant.

The Court also rejected IRS's contention that the frequency of sales, along with the nature and extent of SLRD's business, showed that gains from the sale of the TM parcels should be ordinary in character. The Court found that IRS's description of the pattern of sales after 2008 was inconsistent with the record. SLRD's sales were infrequent, and the extent of SLRD's business was extremely limited. After 2008, SLRD disposed of its entire property in just nine sales over eight years (not counting conveyances to the City of Sugar Land, for which SLRD received no consideration). Further, the TM parcels had not been developed into a subdivision when they were sold, and little or no development activity occurred on those parcels for at least three years before sale.

Further, the TM parcels (which were all west of an easement) were all sold to Taylor Morrison in a transaction that represented a sale of well over half of SLRD's property holdings. With the exception of a one-acre parcel sold to a county, all of the other parcels sold by SLRD (which were all east of that easement) were conveyed to related parties. The balance of the property was conveyed for no consideration (rather than sold) to the City of Sugar Land at various times. In sum, leaving aside the land that was conveyed for public use, after 2008, SLRD sold all of the undeveloped property west of that easement in a single extended transaction to a single buyer, Taylor Morrison, and sold the remainder to related entities.

The Tax Court also rejected IRS's suggestion that the Court should impute to SLRD development activity which was performed on the eastern parcels by related parties. IRS offered no legal authority or any evidence in support of this position, and the case law appeared to be to the contrary. The Court determined that the TM parcels were clearly segregated from the other parcels by the easement (and the levee) and were sold in bulk to a single buyer.

In addition, the Tax Court also found either irrelevant or consistent with investment intent the facts that IRS argued to show that there was a connection between the TM parcels and the parcels east of the easement: (1) they were all covered by the same development agreement with the City of Sugar Land; (2) Taylor Morrison agreed to develop the TM parcels in accordance with various restrictions in the land sale deal; and (3) SLRD was to receive certain payments whenever certain conditions were met. A seller of property, whether an investor or a dealer, might reasonably draft the sale agreement so as to ensure that it would not retain personal liability with respect to the property or to ensure that the buyer would not decrease the value of adjoining properties the seller continues to hold. And the additional payments provided for in the TM-2 and TM-3 contracts were largely irrelevant to the adjustment at issue in this case. While it was true that the TM-2 and TM-3 contracts provided for various additional payments when a plat was recorded or when a home sale closed, the nature of these additional payments did not illuminate the character of the net gain at issue. Even if the Court were to assume that the additional payments would be treated as ordinary income if and when they should accrue, that circumstance would shed little light on the character of the net gain recognized in 2012 because the 2012 net gain included no such additional payments.