Sale of Excess Real Estate Lots Produced Capital Gains
| Sale of Excess Real Estate Lots Produced Capital Gains |
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The Tax Court in Rice, TC Memo 2009-142, held that profits the taxpayers, husband and wife, received from the sale of excess lots that were part of a larger piece of property that they had purchased to build their dream home were capital gains, because the property was held for investment purposes and not for sale to customers in the ordinary course of business. The taxpayers lived and worked in Texas where they had a business that designed and administered 401(k) plans and managed investments for trust instruments, 401(k) plans, and individuals. The husband was a certified public accountant and did tax planning and consulting work before he and his wife started their own business. The taxpayers reported income from their business in excess of $1 million each year. The taxpayers wanted to purchase a lot in Austin to build their dream home. They looked at two properties before settling on the lot they purchased. The first property offered half-acre lots for $200,000 each, but the taxpayers would have had to buy at least two lots to accommodate their needs. The second property offered larger lots, but they were located in an undesirable location. Finally, the taxpayers saw a sign advertising 14.4 acres of undeveloped property in a desirable location near a preserve. The property was for sale as a unit. That is, the property was not subdivided and the taxpayers could not purchase a portion of it. The taxpayers purchased the property within a week for $300,000 with no financing. The taxpayers initially wanted to keep the entire property for themselves, but the taxpayer-wife was worried about feeling isolated. Even though her husband did not want to subdivide the property, he relented. The taxpayers never engaged in the sale of real estate other than sales of their own personal residences before they purchased this property, nor did they engage in real estate sales since. The taxpayers identified the largest and the most desirable place on the property for their lot, and hired consultants for zoning, access, water and wastewater service, construction, and environmental issues. After they decided to subdivide the property, the taxpayers hired a consultant to provide a subdivision layout. They applied for and received a zoning change to subdivide the property into ten smaller lots. The taxpayers began building their house. In the process, they changed the name of the subdivision to Sette Terra after seeing Cinque Terre on a trip to the Italian Riviera. The record established that the taxpayers “did not want just any neighbors”—“[t]hey wanted neighbors with money.” They registered the subdivision for a homeowner's association and executed a declaration of covenants, conditions, and restrictions. The taxpayers' hired an architect to build an “Italian style” house that took two years to build. During this time, the taxpayers did not put much time or attention into selling the excess lots. Their first lot sale was to friends in 2000. In 2002, they placed a wooden sign at the entrance to the subdivision advertising that lots were available for sale. Ultimately, all of the lots were sold through word of mouth rather than traditional advertising. In 2004, the taxpayers sold Lots 9 and 10 at a loss to the taxpayer-wife's sister and her husband. They also sold a lot to friends the same year, realizing a gain of $89,330. Eventually, the taxpayers sold the remaining lots to friends and acquaintances, reserving one lot for their daughter. The Tax Court said that the issue before it was whether the taxpayers held the property primarily for sale to customers in the ordinary course of business or whether the property was held as a capital asset. If the property was held primarily for sale in the ordinary course of business, the profit the taxpayers received on the sale of the lots must be treated as ordinary income. If the property was a capital asset, however, the profit must be treated as capital gain. Under Section 1221(a) a capital asset is broadly defined as property held by the taxpayer, whether connected with his or her trade or business, subject to several exceptions, including stock in trade, inventory, and property held primarily for sale to customers in the ordinary course of a taxpayer's trade or business. The court said that whether property is held primarily for sale to customers is “purely factual,” and to answer that question required an examination of the taxpayer's intent at the time he or she disposes of the property. The court added that it generally examined several factors when analyzing a situation like the one before it:
Applying the factors to the facts of the case, the court determined that the taxpayers held the property as a capital asset. Specifically, the court said that the taxpayers purchased the property to build their dream home and that the record showed that they sold the excess lots to dispose of unwanted property. The taxpayers established that they looked at other properties, but the one they purchased was in the school district where they wanted to live, gave them enough space to build their dream home, and was much cheaper than the other properties they considered purchasing. Further, the taxpayers did not have the option of buying a smaller portion of the property, and they disposed of the excess lots only after the wife decided that she wanted neighbors. The court added that the number of lots sold by the taxpayers was small, which was significant because the Fifth Circuit Court of Appeals, to which the case is appealable, held that substantiality and frequency of sales is among the most important factors. The taxpayers did not sell an average of a lot a year. Rather, among the eight lots that were suitable for construction, the taxpayers sold three lots in 2004, and one lot each in 2000, 2005, 2007, and 2008. Moreover, although the taxpayers made significant improvements to develop and sell the excess lots, the court found that many of the improvements would have been necessary even if they did not subdivide the property. That is, building their own residence on the property required the taxpayers to make significant expenditures for improvements. The court then reviewed the taxpayers' solicitation and advertising efforts and brokerage activities and found that the taxpayers devoted very little time to the sale of the excess lots, which were sold primarily to friends, friends of friends, and family. Other than posting a sign outside the subdivision, the taxpayers did not advertise or promote the sale of the lots. The court stated that the taxpayers had full-time jobs and devoted little time to the sale of the excess lots, the sales accounted for a small percentage of their yearly income, and the taxpayers retained the sales proceeds rather than buying additional inventory. Thus, the court determined that the taxpayers were not real estate developers, as they had never developed land before and they did not develop land since. The court concluded that the taxpayers bought the property as an investment and not as property primarily for sale to customers in the ordinary course of business. Because the taxpayers properly claimed capital gains treatment from the sale of the lots at issue, cooperated with the audit of their taxes, and provided their records to their accountant who prepared their income tax returns, the court also held that the taxpayers were not liable for an accuracy-related penalty. |
