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Real Estate Developers Pay Attention: Preserving Capital Gains Revisited by Tax Court

In Fargo v. Commissioner, TC Memo. 2015-96, the Tax Court reminded taxpayers and practitioners alike that a single sale can result in dealer treatment and, perhaps even more importantly, that: (1) the taxpayer bears the burden of proof that the IRS’s re-characterization of the gain recognized on a sale of property as ordinary income was incorrect; and (2) where investment and development (i.e., sale to customers) motivations coexist with respect to a particular property, the primary motivation will dictate whether the gain or loss recognized on the sale of such property is capital or ordinary.

In this case, the Tax Court held that the taxpayers never abandoned their original and primary intent to develop and later sell residential townhomes to customers as part of their regular business activities and that such intent remained their primary motive for holding the real estate. There were a number of “good” facts for the taxpayers, but not enough to convince the Tax Court that their primary intent had changed from development to holding the property for investment.

The Tax Court evaluated the taxpayers’ primary purpose with respect to the real estate at three distinct times—acquisition (1988), disposition (2002) and the time between these dates. Based on the facts of the case, the Tax Court concluded the taxpayers’ initial purpose in acquiring the real estate was for development.

In evaluating the taxpayers’ purpose with respect to the property at the time of sale, the Tax Court rejected the taxpayers’ argument that their primary purpose for holding the real estate changed from development to investment with the downturn in the local real estate market. The Tax Court found that the taxpayers never abandoned their development plan because they continued to pursue financing and incurred expenses, such as architectural, engineering and appraisal fees, related to development until the sale to an unrelated third party developer in 2002.

The Tax Court pointed to the construction-in-progress account, which had a balance of approximately $1.9 million, of which almost $1 million was incurred in 2001 immediately prior to the 2002 sale. The court did not find such expenditures to be indicative of a changed intent.

In addition to these expenditures, the taxpayers also made two critical mistakes in structuring the sale of the real estate to the developer that undermined capital gains treatment. First, the taxpayer agreed to reduce the original offer by $1.5 million in exchange for a share of the profits from future home sales by the developer. This sharing in the future profits of the developer led the Tax Court to conclude that the taxpayers “were clearly interested in the development profit at the time of the sale.” (Emphasis added.)

The second mistake was agreeing “to continue its best efforts with the development process already in place.” Although the Tax Court’s opinion is not clear whether this obligation of the taxpayer was a pre- or a post-closing covenant, Fargo should not have agreed under any circumstance to this covenant if he harbored any hope of treating the gain on the sale of the real estate as capital gain. This covenant explicitly states that the taxpayers’ intent at the time of sale was one of development, not investment.

The taxpayers would have been better served to accept the original offer and not agree to undertake any further “development” activities. Perhaps, the fifth and eighth factors may have moved to the “taxpayer” column, in which case the Tax Court might have ruled differently.

Although Fargo is a Tax Court memorandum decision, it serves as a cautionary tale for taxpayers with stalled real estate development projects. Here, the Tax Court did not accept the taxpayers’ argument that they held the real estate primarily for investment purposes. While there was an investment motivation, the court considered it to be secondary to development. Consequently, the Tax Court upheld the IRS’s re-characterization of the gain recognized by the taxpayers on the 2002 sale of the real estate as ordinary income.

Brian S. Masterson