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.