Tax Court Holds that Sale of Real Property Resulted in Ordinary Income Rather than Capital Gain

In Fargo,[1] the Tax Court held that a couple had ordinary income from a property sale by a partnership in which they were partners because the property was sold in the ordinary course of business.  The taxpayer, husband and wife, were partners in Girard Development, L.P. (GDLP), an entity subject to the partnership procedures under Section 6626.  The primary issue for decision was whether the sale of certain property by GDLP generated capital gain or ordinary income for the taxpayer.

The taxpayer was engaged in the real estate business through a variety of business entities, including GDLP and Fargo Industries Corp (“FIC”).  FIC acquired a leasehold from La Jolla Medical Building Corp., an unrelated entity, to lease a 2.2 acre parcel of real estate (the “La Jolla Property”) including its building and site development plans.  FIC acquired the leasehold in the La Jolla Property with plans to develop a 72-unit apartment complex and retail space.  The leasehold was purchased for $2.7 million and the lease agreement originally ran through 2008, but was subsequently extended to run through 2042 for additional consideration of $900,000 in order to allow the taxpayer more time to develop the La Jolla Property.

When FIC acquired the leasehold in the La Jolla Property, it also acquired the improvements that had been developed by La Jolla Medical Building Corp., including tenant-occupied medical building and certain plans, drawings, reports, surveys and permits.  In 1991, FIC transferred the leasehold in the La Jolla Property to GDLP for a capital contribution credit less than FIC’s basis in the property.  After GDLP acquired the leasehold, several hurdles to develop the La Jolla Property arose, and as a result of such hurdles the development of the La Jolla Property was postponed.  Nonetheless, in another attempt to obtain financing for the project, GDLP purchased the La Jolla Property from a La Jolla Country Club in 1997 in fee simple for $1,750,000.

The court found that through 2001, the La Jolla Property was developed for residential use.  The extent of physical improvements was limited to minor repairs.  At the end of 2001, the balance of the leasehold improvements were reported to be $73,406.55.  Although the taxpayer did not make substantial alterations to the La Jolla Property, GDLP capitalized substantial amounts for construction in progress.  From 1991 through 2001, GDLP capitalized $1,828,982 of construction in progress.  In the years 1999, 2000 and 2001, GDLP incurred costs for construction of $233,000, $216,337 and $999,585, respectively.  These costs primarily comprise architecture, engineering, appraisal, permits and licensing fees (not physical improvements to the property itself).

Before GDLP purchased the leasehold, La Jolla Medical Building Corp. used the building as rental space for medical offices.  After the 1989 acquisition of the leasehold, rental income was generated from tenants occupying the medical offices.  From 1989 until the time the property was sold, the rental income was the only income generated from the La Jolla Property.  In addition to collecting rent, the taxpayer’s related companies used the building for their various business operations.

No substantial efforts were made to solicit potential buyers for the La Jolla Property prior to 2001.  GDLP never listed the La Jolla Property for sale and never marketed it to real estate developers.  In 2001, Centex Homes, an unrelated entity, made an unsolicited offer to purchase the La Jolla Property for $16 million. The purchase price was subsequently renegotiated for $14.5 million plus a share of the home sales profits.  Centex Homes purchased the La Jolla Property from GDLP in 2002 to develop residential townhouses largely on the basis of previous plans that the taxpayer’s entities had developed.  The sale contract between GDLP and Centex Homes obligated GDLP to continue its best efforts with the development process already in place.  After Centex Homes purchased the property, GDLP incurred subsequent development costs that were reimbursed by Centex Homes.

The question for determination in the case was whether gain from the sale of the La Jolla Property resulted in ordinary income or capital gain (i.e., should GDLP be treated as a “dealer”  and recognize ordinary income or as an “investor” and recognize capital gain).  The IRS argued that the sale of the La Jolla Property to Centex Homes produced ordinary income, whereas GDLP argued that the sale produced capital gain because it held the La Jolla Property for investment purposes.

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.  Citing Malat v. Riddell,[2] the Tax Court has held that the term “primarily” for purposes of Section 1221(a)(1) means “of first importance” or “principally.”  The court then identified several factors for evaluating whether a taxpayer holds property primarily for sale to customers in the ordinary course of business, including the following:

1. The purposes for which the property was initially acquired;
2. The purposes for which the property was subsequently held;
3. The extent to which improvements, if any, were made to the property by the taxpayer;
4. The frequency, number and continuity of the sales;
5. The extent and nature of the transactions involved;
6. The ordinary business of the taxpayer;
7. The extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property;
8. The listing of property with brokers; and
9. The purpose for which the property was held at the time of sale.[3]

The court found that the purpose for which the property was initially acquired favored the IRS because FIC’s original intent when it acquired the leasehold in 1989 was to develop the La Jolla Property was for resale to customers.  The court also stated that GDLP’s 1997 purchase of the La Jolla Property in fee simple to improve chances of obtaining development financing further evidenced GDLP’s intent to resell the La Jolla Property to customers in the ordinary course of its business.

The court also found that the purpose for which the property was subsequently held favored the IRS, because GDLP never abandoned its original development plan, as evidenced by its multiple attempts to obtain financing and by the expenses it incurred over the years for architectural, engineering and appraisal fees.

With respect to the third factor, the extent of improvements to the property, the court found that this factor favored the taxpayer because the taxpayer never built any structures, roads or dwellings of any kind on the La Jolla Property.  The court also found that the fourth factor, the frequency, number and continuity of sales, clearly favored the taxpayer because GDLP had never sold any real estate before the sale of the La Jolla Property.

With respect to the fifth factor, the extent and nature of the transactions involved, the court found this factor favored the IRS.  Specifically, the extent and nature of the transaction involved was the sale to Centex Homes, which, under the purchase agreement, allowed GDLP to share in the development profit.  The court did not address the sixth factor, the ordinary business of the taxpayer.

The court found that the seventh and eighth factors, the extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property, and the listing of property with brokers, favored the taxpayer.  However, with respect to the last factor, the purpose for which the property was held at the time of the sale, the court found that this factor favored the IRS because GDLP had incurred substantial development costs and had taken several strategic moves to acquire financing to fund development and had been continually increasing its developmental efforts with respect to the La Jolla Property immediately prior to the sale.

Based on its analysis of the factors, the court concluded that GDLP sold the La Jolla Property in the ordinary course of business under Section 1221(a)(1).  The court stated that GDLP purchased and held the La Jolla Property primarily to develop it and later sell it to customers and this intent was never abandoned and remained the primary motive for holding the La Jolla Property as a part of its regular business activities.  In addition, the court noted that GDLP incurred significant development expenses with respect to the La Jolla Property (although GDLP had not made physical improvements to the property).

Although the court recognized that the La Jolla Property was used as rental property and GDLP and all related entities maintained their offices on the property, the court found that the rental of the La Jolla Property to third parties and the use of the La Jolla Property by GDLP’s affiliates was not GDLP’s primary purpose of holding it, but rather GDLP was simply making its best use of the La Jolla Property as office and rental space while never abandoning its primary intention of selling the La Jolla Property.

Observation

The holding of the court that GDLP was a “dealer” rather than an investor with respect to the La Jolla Property, thereby generating ordinary income versus capital gain, is interesting given the fact that GDLP made no physical improvements to the property itself and only made a single sale of property to one buyer (two of the factors to which many courts give the greatest emphasis).[4]  In this case, the court placed primary emphasis on the intent of the taxpayer at the time of purchase and at the time of the sale of the property, and found GDLP to be a “dealer” despite the fact that no physical improvements were made to the property and that the taxpayer only made a single sale to one buyer.

 [1] TCM 2015-96.

[2] 383 U.S. 569 (1966).

[3] See Maddux Construction Co., 54 TC 1278 (1970).

[4] See, e.g., Biedenharn Realty Co., 526 F.2d 409 (CA-5 1976).