Evidence of development intent plays key role in determining capital gains treatment

One of the most frequently litigated areas of the tax law is whether real property is held for investment as a capital asset or the taxpayer is holding the property primarily for sale to a customer in the ordinary course of his trade or business—a determination that could mean a 15 percent increase in a taxpayer’s marginal tax. In June 2015, the US Tax Court held in Fargo v. Commissioner, TC Memo 2015-96, that the taxpayers were not entitled to capital gains treatment for the sale of real estate because the property was held for development and the taxpayer did not abandon its development intent.

The taxpayers, who were actively engaged in a real estate business through a variety of business entities, acquired a leasehold interest in a parcel of real estate including an occupied medical office building and site development plans located in La Jolla, California. Through a partnership, the taxpayers entered into various agreements with related entities for the development and management of the property, which required fees for such services. The development of the property was suspended due to several hurdles and the decline in the local real estate market; however, the taxpayer continued to seek financing to develop the property and eventually acquired the property. In 2001, an unrelated homebuilder made an unsolicited offer to purchase the property for $16 million, which was subsequently renegotiated and sold for $14.5 million plus a share of the home sales profits.

Real estate held for sale in the ordinary course of business is not eligible for capital gains treatment. The determination of whether a taxpayer holds property in the ordinary course of business rests on the facts and circumstances of each taxpayer. While there is no fixed formula for determining the character of real estate, the courts have historically analyzed the following factors:

  1. The nature and purpose of the acquisition of the property
  2. The nature and purpose of the property during ownership of the property
  3. Whether the taxpayer improved the property and to what extent
  4. The number, extent, continuity, and substantiality of sales
  5. The extent and nature of the transactions involved
  6. The extent of advertising, promoting, or otherwise soliciting buyers for the property
  7. Whether the taxpayer listed the property with brokers
  8. The purpose of holding the property at the time of the sale

In this case, the taxpayers argued that during their ownership only minor improvements were made to the property; there were no previous sales; and there were no substantial marketing, advertising, or brokerage efforts for the property. Additionally, the taxpayers argued their intent changed over time, as they continued to hold the property for investment purposes while waiting for the economy to recover. Despite their argument, the opinion of the Tax Court centered on the fact the development intent of the taxpayers was never abandoned. This conclusion was reached due to the taxpayers’ continued attempts to obtain financing for development; their expenditures for soft costs such as architects and engineers; the sale of the taxpayers’ development plans to the buyer; and the taxpayers’ continued interest in the home sales profits. Accordingly, the Tax Court determined the taxpayers’ gain from the sale was not entitled to capital gains treatment.

This case illustrates the principal lesson that all facts and evidence presented are considered in the evaluation of whether or not a taxpayer holds real estate in the ordinary course of business. In Fargo, even though many of the facts weighed in favor of the taxpayer, the court placed its strongest emphasis on the taxpayers’ intent at acquisition and lack of factors to substantiate the taxpayers’ abandonment of such intent. Taxpayers should be aware that the evidence of development intent, even acts such as incurring soft costs and participating in the upside of ultimate development profits, may be sufficient to deny capital gains treatment. Taxpayers should be mindful of continuing relationships with the development entity when selling for capital gain.

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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.