Category: Real Estate
Subject: Capital Gain
Title: Subdivided Real Estate
IRC Sections: 1221
Filename: 1098.html
Date Produced: 4/97

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
I refer to our conversations of April 7, 8 and 9, 1997 and to your memorandum of April 8, 1997. The taxpayers in this case are four individuals, a father and his three adult children. The father is a practicing attorney. One child is a waiter and bookkeeper, one a wine chemist, and the third a physical therapist.

The father received a 40% interest in a tract of land by gift from his mother in the 1970's. The value of the interest at that time was somewhere between $45,000 and $50,000. The three children received the remaining 60% ownership of the property by inheritance when the mother (the grandmother of the children) died in 1989. The value of the 60% interest at that time was approximately $204,000.

Prior to this matter, none of the parties had engaged in any significant activity in the real estate business. The parties, led by the father, injected approximately $320,000 into the property for roads, gutters, sidewalks, sewers, etc. The property was subdivided into 8 residential lots. 4 were sold in 1996, and the remainder should sell in 1997. The lots sell for between $150,000 and $155,000, each.

The parties placed "for-sale" signs at the property and advertised the lots for sale in the local newspaper, spending approximately $1,500 for advertising. The lots were sold by the father, personally: no real estate agent was involved.

Obviously, the issue is whether there is a reportable position that the gain on sale of the property is capital gain. Discussion
As you are painfully aware, there is no bright-line test to determine whether a property is held for investment and thus gives rise to capital gain on sale; or in the alternative, whether a property is held for sale in the ordinary course of business thus giving rise to ordinary income on sale. The issue is a mixed question of fact and law which has given rise to more litigation than perhaps any other issue in the tax literature.

The courts have produced a variety of factors to consider in making this determination none of which is controlling and many are often given conflicting degrees of emphasis by different courts.

In my view, the following factors weigh against the taxpayers in this matter.

1. There is substantial development activity taking place over a short period of time. This factor is ordinarily given great weight.

2. The amount of development cost is substantial in relation to the value of the property and contributes substantially to the amount of gain that will be realized.

3. The taxpayer (the father) sold the lots through advertising and his own personal efforts instead of using a real estate agent.

4. The amount of gain from the sales will be substantial in relation to the taxpayers' other sources of income, particularly the children.

In my view, the following factors are in the taxpayers' favor in this matter.

1. The taxpayers have held the property for many years.

2. The property is not somehow connected to any other trade or business activity conducted by the taxpayers.

3. The taxpayers have not and will not acquire additional property for development.

4. The development of this property is an isolated event in the tax lives of the parties which event sharply contrasts with their history and (based on the statements of the parties) their future activities.

5. The number of actual sales (eight) is relatively low.

Based on the factors set forth above, I believe that the taxpayer's in this matter have a clear filing position for claiming capital gain treatment, albeit a position that carries with it significant risk and uncertainty. Clearly, the taxpayers' behavior prior to the development and subdivision of the property was completely consistent with that of a passive investor. The IRS would likely argue, with considerable justification, that the taxpayers' investor posture changed as a result of the development activities.

Does the fact that the taxpayers received the property through gift or inheritance substantially mitigate other factors that favor dealer characterization? In Riedel v. Comr., 261 F2d 371, 58-2 USTC ¶9966 (CA 5, 1958), reversing 16 TCM 946; the taxpayers inherited a tract of land and used it for many years as pasture land. They decided to sell the land, and employed an engineer to build roads and to subdivide the property into 31 separate lots. The Tax Court found the taxpayer had sold the lots in the ordinary course of business. The Court of Appeals for the Fifth Circuit reversed the decision on the grounds that the facts of the case do not give rise to the legal inference that the taxpayers were in the ordinary course of selling lots.

I think this case is very similar to the facts at hand and significantly improves the taxpayers' position in this matter. Particularly in light of Riedel, I believe the taxpayers have a solid filing position for claiming capital gain from the sale of these lots; however, I strongly advise putting the taxpayers on notice in writing that 1) there can be no assurance as to the outcome of this matter if it is ultimately scrutinized; and 2) there is a substantial amount of risk involved with this position.