Mark S. Gardner, TC Memo 2011-137
The Tax Court has determined that a contractor who bought a parcel of land with the intent of building multi-family housing to generate rental income, but instead sold three subdivided lots due to financial pressures, held the property as an investor and realized short-term capital gain on the lots' sale. The Court also determined that the contractor wasn't entitled to deduct taxes and engineering costs associated with a separate property that was later sold at a profit, finding that they were pre-production costs that must be capitalized under Code Sec. 263A.
Observation: Although short-term capital gains are taxed at regular income tax rates (35% maximum), the distinction between ordinary and capital gain was nonetheless important for the self-employed contractor in this case. Under Code Sec. 1402(a)(3)(C)(ii), a self-employed individual can exclude the gains on the sale of real estate from self-employment income unless he realized the gains from property held primarily for sale to customers in the ordinary course of business.
Background on real estate gains. A capital asset is broadly defined in Code Sec. 1221(a) as “property held by the taxpayer” subject to a number of exceptions, including property held primarily for sale to customers in the ordinary course of trade or business.
Real property produces tax-favored capital gain or loss on its sale or exchange if it's a capital asset. The main reasons for the exclusion of real property from the capital asset category are (1) that it's property held by the taxpayer primarily for sale to customers in the ordinary course of his business (i.e., dealer property), and (2) that it's real property used in his business. (Code Sec. 1221(a)(1), Code Sec. 1221(a)(2)) The tax consequences of being labeled a real estate dealer, as opposed to an investor, can be significant.
Whether real property is held primarily for sale to customers in the ordinary course of the taxpayer's business is a factual question determined by the circumstances of each case. Under Mathews v. Commissioner, (CA 6 1963) 11 AFTR 2d 1077, factors which are considered include:
(1) the purpose for which the property was acquired;
(2) the purpose for which it was held;
(3) the existence and extent of improvements made to the property by taxpayer;
(4) the frequency, number and continuity of sales;
(5) the extent and substantiality of the transactions;
(6) the nature and extent of taxpayer's business;
(7) the extent of advertising to promote sales, or the lack of such advertising; and
(8) listing of the property for sale directly or through brokers.
Background on capitalization. In general, capital expenditures are amounts paid for the acquisition of property or for a permanent improvement or betterment of the property extending beyond the tax year. (Code Sec. 263) Code Sec. 263A provides that certain direct and indirect costs of property produced by the taxpayer or acquired for resale are subject to the uniform capitalization rules, without regard to whether those costs are incurred before, during, or after the production period. (Reg. §1.263A-2(a)(3) Under these rules, costs properly allocable to real and personal property acquired for resale and described in Code Sec. 1221(a)(1) must be capitalized. (Code Sec. 263A(a)(1)(B)
Facts. Mark Gardner, a self-employed individual who described his business on his 2004 Schedule C as “carpentry/site contracting,” bought and sold 16 parcels of real property over 26 years. He would sometimes buy unimproved land, build a single-family residence, and sell the property; sometimes he would simply sell the unimproved land; and sometimes he would buy land and either improve the existing multi-family housing or construct new multi-family housing. He would typically retain the multi-family housing that he constructed or improved and earn rental income from the properties, although he also sold a couple of the multi-family units as well.
In March of 2004, Gardner purchased property from his brother that had been approved for subdivision into five lots. He built a road to access the lots and built a house on one of the lots and conveyed it to his brother. He sold three of the remaining lots in November for $750,000, which he and his wife reported as generating a short-term capital gain of $373,841. Gardner testified that the three lots were appropriate for duplex housing and that he had originally intended to build multi-family homes on the lots, but that he had to sell them because of the expenses of building the road. The remaining lot was sold in 2005 for $215,742.
IRS recharacterized the sale of the three lots as a sale of property held for customers in the ordinary course of business, resulting in an increase in Gardner's earnings from self-employment and the imposition of self-employment tax.
Gardner also owned a 34-acre industrial lot during the year at issue (2004), which he had purchased in’97 for $400,000, obtained approval to subdivide, and later sold in 2006 for $4 million. During 2004, Gardner kept some heavy equipment related to his carpentry business on the property, but he didn't rent the property to anyone during the time that he owned it.
On Schedule E, Supplemental Income and Loss, for 2004, Gardner claimed a $99,956 deduction with regard to the industrial lot, including engineering fees relating to surveying and subdividing the property (originally designated on the Schedule E as “legal and other professional fees”), mortgage interest, and real estate taxes. IRS disallowed these expenses because they didn't relate to rental of the property.
Parties' arguments. IRS argued that Gardner's history showed that he was a dealer, and that his purpose in acquiring the property from his brother was to sell the subdivided lots. However, while conceding that he was a dealer with regard to some properties, Gardner claimed that he was also an investor. He argued that the extent and duration of his multi-family property holdings was evidence of their investment value.
Partial taxpayer win. The Tax Court, noting that Gardner was a credible witness, found that he purchased the residential property from his brother for investment purposes to build duplex rental units on the three lots. The Court also found that, in general, Gardner's purchase or construction of multi-family rental units was for the purpose of investment (in the form of rental income and appreciation), rather than for immediate sale to customers. Although Gardner had sold two of the multi-family rental units, he did so after holding them for several years, and he had other rental units that he has owned for over 20 years. Accordingly, the three lots sold in 2004 were not held primarily for sale to customers in the ordinary course of business, but were instead capital assets generating short-term capital gain.
However, the Court rejected Gardner's claim that the engineering service fees and real estate taxes with regard to the industrial lot were deductible under Code Sec. 162, finding instead that they were pre-production costs under Reg. §1.263A-2(a)(3)(ii). As such, since the property was reasonably likely to be subsequently developed at the time these costs were incurred, they had to be capitalized under Code Sec. 263A.
The mortgage interest expense fell outside of Code Sec. 263A, however, because Code Sec. 263A(f) only requires interest to be capitalized if it was paid or incurred during the “production period.” Thus, since the 2004 interest was incurred before any physical production activity began, it was not required to be capitalized. In so holding, the Court concluded that neither Gardner's planning and design activities, nor his storage of certain equipment on the property, constituted a physical production activity.
References: For whether realty is held primarily for sale to customers, see FTC 2d/FIN ¶I-6302; United States Tax Reporter ¶12,214.31; TaxDesk ¶250,502; TG ¶10902. For capitalization of pre-production expenses, see FTC 2d/FIN ¶G-5463; United States Tax Reporter ¶263A4.04.