Small Business Taxes & Management

Special Report

Capital Gain or Ordinary Income?


Small Business Taxes & ManagementTM--Copyright 2015, A/N Group, Inc.




There aren't too many ways to achieve permanent tax savings any more. The best one is selling an asset and getting capital gain treatment on the sale. Capital gain treatment is allowed on the sale of a capital asset, but not one held for sale to customers in the ordinary course of business. For example, if Fred is a farmer and buys a tractor for $75,000 and sells it more than a year later for $82,000, he'll have a long-term capital gain of $7,000 (ignoring depreciation). On the other hand, if Fred's a tractor dealer the gain would be ordinary income. Things get tricky when you're sometimes a dealer and sometimes an investor. For example, if Fred was both a tractor dealer and a farmer. Then the treatment would depend on how the tractor was used. That's frequently the situation with real estate where real estate professionals (brokers, developers, contractors, etc.) may be investors with respect to one or more properties they own and dealers with regard to other properties. It was the issue in the case described below.


Facts of the Case

The facts of the case Victor Fargo and Virginia King; Girard Development, L.P., Girard Management Corporation, Tax Matters Partner (T.C Memo. 2015-96) are somewhat complicated, but important. There were also other issues in this case, but we're only concerned with whether the sale of the real estate produced capital gain or ordinary income.

The taxpayers, Fargo and King, were engaged in the real estate business during the years at issue. Ms. King is a licensed real estate broker in California. The couple conducted their business through a number of entities, including GMC; Fargo Industries Corp. (FIC), a C corporation wholly owned by Mr. Fargo; King Real Estate, Inc. (KRE), a C corporation wholly owned by Ms. King; Girard Property Corp. (GPC), a C corporation wholly owned by Ms. King; and GDLP, a TEFRA partnership of which Mr. Fargo and Ms. King are directly or indirectly the majority partners and GMC is the tax matters partner. Numerous commercial real estate developments were conducted through their related entities.

The background of the real estate transaction in issue began in December 1988. FIC acquired a leasehold from La Jolla Medical Building Corp., an unrelated entity, to lease a 2.2-acre parcel of real estate (La Jolla property) including a building and site development plans. The owner of the La Jolla property was La Jolla Country Club. FIC acquired the leasehold in the La Jolla property with the plans to develop a 72-unit apartment complex and retail space. The leasehold was purchased for $2,700,000, paid in installments ending in 1990. The lease agreement between FIC and the La Jolla Country Club initially ran through 2008 but was subsequently extended to run through 2042 for additional consideration of $900,000. The lease was extended to allow Fargo and King 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 a tenant-occupied medical building and certain plans, drawings, reports, surveys, and permits.

The lease agreement between the La Jolla Country Club and La Jolla Medical Building Corp. was due to expire on August 31, 2008. In order to extend the term of the lease past August 31, 2008, La Jolla Medical Building Corp. had to meet certain conditions precedent, including redeveloping the La Jolla property according to the terms of the lease agreement. FIC acquired La Jolla Medical Building Corp.'s lease with the same constraints.

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. At the time of its formation and the contribution of the leasehold, GDLP entered into various agreements with related parties for the development and management of the La Jolla property. Those agreements provided for the payment of various fees for such services. After GDLP acquired the leasehold, several hurdles to the development of the La Jolla property arose. In the early 1990s the real estate market in La Jolla declined dramatically. As a result, development of the La Jolla property was suspended. Nonetheless, Mr. Fargo sought financing to develop it. In another attempt to obtain financing, GDLP purchased the La Jolla property from the La Jolla Country Club in 1997 in fee simple for $1,750,000.

In 1993 Norby, Inc. (Norby), an unrelated entity with which Mr. Fargo and FIC had previously worked, filed a lawsuit against Mr. Fargo and FIC because Mr. Fargo and FIC had defaulted on a $10 million loan for an unrelated development project. The parties negotiated to partially resolve the Norby litigation with a partnership interest in GDLP, and Norby acquired a partnership interest in GDLP in October 1991. The negotiations resulted in an amended partnership agreement, an amended marketing and brokerage agreement, and a property management agreement.

Through 2001 the La Jolla property was developed for residential use. The extent of physical improvements was limited to minor repairs. These minor repair costs were capitalized and amortized over the course of the holding period. Although Fargo and King did not make substantial alterations to the La Jolla property, GDLP capitalized substantial amounts for 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 comprised architecture, engineering, appraisal, permits, and licensing fees.

Before GDLP purchased the leasehold, La Jolla Medical 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, Mr. Fargo's rental companies used the building for their business operations. FIC, GDLP, and other entities owned by Fargo and King used the building as office space for accounting, bookkeeping, and other business purposes.

After 1989 the La Jolla property was maintained as a business location and rental property. In 1993 GDLP entered into an agreement with KRE, a real estate management company owned by Ms. King. The agreement provided that KRE would manage, operate, maintain, and lease the La Jolla property. GDLP paid KRE $3,000 a month for its services.

No substantial efforts were made to solicit potential buyers for the La Jolla property before 2001. GDLP never listed the La Jolla property for sale and never marketed it to real estate developers. The only effort to sell the La Jolla property was made in 1993, when GDLP entered into a marketing and brokerage agreement with GPC, a real estate brokerage company owned by Ms. King. Nonetheless, GPC never undertook substantial efforts to sell the property.

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 $14,500,000 plus a share of the home sales profits. Centex Homes purchased the property from GDLP in 2002 to develop residential townhouses largely on the basis of previous plans that Mr. Fargo's entities 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. In 2004 GDLP sued Centex Homes. As a result of the litigation, Centex Homes paid GDLP an additional $1,500,000 in full satisfaction of any amounts that may have been due under the sale contract.


The Court's Opinion

These cases present the question of whether gain from the sale of real property resulted in ordinary income or capital gain. The IRS contended that the sale of the La Jolla property to Centex Homes produced ordinary income.

GDLP argued the sale produced capital gain because it held the land for investment. 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". Section 1221(a)(2) provides that a "capital asset" does not include "real property used in . . . the taxpayer's trade or business".

The Supreme Court has held that it is appropriate to construe the definition of capital asset narrowly while simultaneously construing the Code's definition of exclusions from capital asset status broadly. Whether a taxpayer held specified property primarily for sale to customers in the ordinary course of business is a question of fact. The term "primarily" for purposes of Section 1221(a)(1) means "of first importance" or "principally". The Tax Court has identified several factors for evaluating whether a taxpayer held certain properties primarily for sale to customers in the ordinary course of business, including:

(1) the purpose for which the property was initially acquired;
(2) the purpose 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 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.

Upon review of the relevant factors, the Court concluded that GDLP had not sufficiently established the facts necessary to its case, nor had it carried its burden of proving respondent's determinations were in error.

1. The Purpose for Which the Property Was Initially Acquired

GDLP and the IRS agree that the initial investment in the La Jolla property was for development purposes. This is evidenced by FIC's original intent when it acquired the leasehold in 1989 to develop the La Jolla property for resale to customers. GDLP's 1997 purchase of the La Jolla property in fee simple to improve chances of obtaining development financing further evidences its intent. However, although a taxpayer's initial motivation in acquiring property is relevant, the ultimate question is the taxpayer's purpose at the time of sale. It is clear that GDLP initially acquired the La Jolla property in the normal course of business, but the crucial factor is the purpose for which the La Jolla property was held at the time of sale.

2. The Purpose for Which the Property Was Subsequently Held

GDLP contended that it held the La Jolla property primarily to allow the La Jolla real estate market to recover from the recession; thus, it should be viewed as an investment. It is well established that a taxpayer in the real estate business may hold real estate as an investment.

Although the Court believed that GDLP held the La Jolla property, in part, to allow the market to recover, it thought that was not GDLP's primary purpose. GDLP never abandoned its development plan, as evidenced by its multiple attempts to obtain financing and by the expenses it incurred for architectural, engineering, and appraisal fees. GDLP incurred substantial fees relating to development expenses, with an accumulated balance of $1,828,982 at the end of 2001. The development expenses were incurred each year between 1991 and 2001, indicating that the developmental efforts were ongoing. This factor weighs in favor of the IRS.

3. The Extent of Improvements to the Property

GDLP contends that during the 10 years it held the La Jolla property it never built any structures, roads, or dwellings of any kind. Although GDLP never took substantial actions to improve the La Jolla property, it did incur $70,407 of accumulated leasehold improvements as of the end of 2001. Some of these improvements, including a new roof for the building, were more properly characterized as general repairs and maintenance. GDLP argues that the improvements were kept to a minimum, evidenced by the fact the building's heating system and elevator remained in disrepair. On the basis of the leasehold improvements alone, the Court believed that GDLP never substantially improved the La Jolla property.

4. The Frequency, Number, and Continuity of Sales

The Tax Court has previously held that frequent and substantial sales of real property more likely indicate sales in the ordinary course of business whereas infrequent sales for significant profits are more indicative of real property held as an investment. The IRS argued that GDLP was in the business of real estate development for sale to consumers.

GDLP had never sold real estate before the sale of the La Jolla property, but other entities that Mr. Fargo owned developed and sold real estate in the normal course of business. However, on these facts the Court believed GDLP's activity alone should be its focus, and it found this factor favored GDLP.

5. The Extent and Nature of the Transactions Involved

It is undisputed that the sale of the La Jolla property was the only sale associated with this transaction. The property was sold to Centex Homes, an unrelated entity, at a fair price with the plan for Mr. Fargo to develop the property and GDLP to share in the resulting profit according to the terms of the purchase agreement. GDLP and Mr. Fargo were clearly interested in the development profit at the time of the sale. Therefore, this factor favored the IRS.

6. The Extent of Advertising, Promotion, or Other Active Efforts Used in Soliciting Buyers for the Sale of the Property

It is undisputed that Centex Homes made an unsolicited offer to purchase the La Jolla property, and it is also undisputed that GDLP was not actively advertising or promoting its sale around the time it was sold. The only effort that GDLP made to sell it was contracting with GPC in 1993. In Maddux Construction Co. the taxpayer similarly discussed a property sale with a real estate broker but did not make any other effort to sell the property. The Tax Court held there that the taxpayer did not make extensive efforts to sell the property with that action alone. Here, GDLP did not engage in marketing, selling, or advertising outside of contracting with GPC. Further, GPC never contacted any buyers or performed substantial marketing or advertising services. Consequently, GDLP has carried the burden of showing that it did not make extensive efforts to sell the La Jolla property.

7. The Listing of the Property With Brokers

The La Jolla property was listed with GPC serving as broker in 1993. Additionally, the record indicates that GPC was paid a fee based on the sale price. This factor weighs in favor of GDLP.

8. The Purpose for Which the Property Was Held at the Time of Sale

At the time Centex Homes purchased the La Jolla property GDLP had incurred substantial development costs and undertaken several strategic moves to acquire financing to fund development. At the time of sale GDLP had been continuously increasing its developmental efforts with respect to the La Jolla property. During 1999 and 2000 GDLP incurred developmental costs of $233,000 and $216,337, respectively, which represent a substantial portion of the total spent on development over the entire holding period. Unlike the taxpayer in Maddux, which had stopped developing the property two years before the sale, GDLP continually engaged in efforts to plan and develop the La Jolla property up until the purchase date. Consequently, this factor would not support the conclusion that the La Jolla property was held simply as an investment at the time of sale.

9. Conclusion

Under the factors discussed above, the Court held that GDLP sold the La Jolla property in the ordinary course of business under Section 1221(a)(1). GDLP purchased and held it primarily to develop it and later sell it to customers. This intent was never abandoned and remained the primary motive for holding the La Jolla property as part of regular business activities. In addition, GDLP incurred significant development expenses. Thus, GDLP failed to show that gain from the sale of the La Jolla property was not subject to ordinary income treatment under Section 1221(a)(1).

The Court recognized that the La Jolla property was used as a rental property and GDLP and all related entities maintained their offices on the property. However, using the La Jolla property as rental property was not GDLP's primary purpose of holding it. In Cottle the Tax Court held that Section 1231 capital gain treatment was applicable to a rental property subsequently sold to liquidate the investment. That is not the case here. GDLP was making its best use of the La Jolla property as office and rental space while never abandoning its primary intention, selling it.  

The Dangers

Here the Court found the taxpayers held the property for sale despite the fact they held it for an extended period of time. The Court also found five of the factors in the taxpayers' favor; three for the IRS, but that last one was decisive.

While each case turns on the individual facts and circumstances, there's no question that this can be a tricky area. You may be able to get the facts to line up in your favor, but it's not easy and it can't be done after you've held the property for some time. Get good advice up front. You may be able to steer the facts in your favor.

Most real estate transactions produce substantial gains, especially for professionals who know the business. That means the taxes involved will also be substantial. On a $100,000 capital gain the difference between ordinary income and capital gain treatment could be as much as $20,000. Even at a more likely spread of $15,000 that's still real money. It also means the penalty for being wrong could amount to more than $3,000. Remember, that's on $100,000 gain; larger gains will produce correspondingly larger tax spreads and penalties. Consultation with a tax professional is very likely to be worthwhile. And if the tax professional is wrong, there's a good chance you might be able to avoid the penalty by claiming reliance on the professional.


Copyright 2015 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 08/07/15