Category: Sales & Exchanges; Real Estate;
Partnerships & LLCs Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Facts 1. Partnership No. 1 (P1) P1 and P2 owned adjacent tracts of raw land suitable for commercial development. P1 purchased its parcel in January, 1994 by exercising an option it had held on the property since October, 1993 (or earlier). P2 purchased its parcel a few years prior to P1's purchase. In October, 1993, P1 and P2 formed a new venture (JV) to which each contributed its respective parcels of land in exchange for a 50% of the capital and profits of JV. JV is a general partnership. Neither P1 nor P2 expended any funds to develop the land in any way. In essence, P1 and P2 did absolutely nothing to the land prior to its contribution to JV. The parcels of land (hereinafter referred to as the Property) are adjacent to an interstate highway, but there is presently no easy access to the Property from the highway. JV has agreed, in conjunction with other area merchants and city and state authorities, to commission the construction of a highway off-ramp and road system in order to provide convenient access to the Property from the interstate highway. The cost of construction is expected to be around $8 million of which JV's portion is $3 million. During 1994, JV paid $250,000 in cash and signed a non-interest bearing note (secured by the land) toward its share of construction costs. The note is to be repaid at the rate of $22,000 per acre of property sold. The cash was paid and the note is owed to the City of Jackson, Tennessee. JV plans to sell 50% of the Property to an unrelated third party. The remainder will be sold to a newly formed corporation, DC, 40% of the stock of which is owned directly by JV. Both sales are expected to be installment sales for tax purposes. DC will assume the $2.75 million note to the City of Jackson. No actual construction work on the highway contract will have begun prior to the sales although engineering studies and other such work has or will be done prior to that time. JV will have done nothing to the Property prior to the sale. JV did, however, incur approximately $125,000 in consulting fees and other expenses related to marketing the property. It is assumed that prior to the sales, no other costs have been or will be incurred by any other party or parties with respect to the Property. The selling price has yet to be determined with certainty, but the parties intend to sell at price equivalent to the expected value of the property after development such that the subsequent sale of the Property by DC will produce little or no gain. Issues 2. Should the note payable to the City of Jackson be booked for tax purposes at face or at some discounted value to reflect imputed interest (because the note is non-interest bearing)? If it is necessary, how would imputed interest be handled from a computational point of view given that payments on the note are tied to property sales, not the passage of time? 3. How much of DC can the partners of JV own without becoming subject to the related party rules within the provisions governing installment sales? 4. Some timber is to be sold off the land owned by JV. Does this affect investment versus trade or business status of the sale of land? 5. Can the cost of the highway off-ramp be added to the cost of the lots when they are ultimately sold by DC? If not, can this cost be recovered through some other means? Answers: Issue 1 Answers: Issues 2 through 5 Commentary: Collateral Issue Discussion: Issue 1 The premise underlying Issue 1 is that substantial development activity is alone sufficient to render JV a dealer with respect to the sale of the Property. There is no bright-line test to determine whether a taxpayer is a dealer or an investor with respect to a given sale. It is clear from existing case law that at least in certain judicial circuits, a pattern of regular, frequent, and continuous sales coupled with substantial development activity will almost certainly be characterized by the IRS and the courts as dealer activity. See Biedenharn Realty Co., Inc. v. U.S., 526 F.2d 409 (5th Cir. 1976), cert. denied, 429 U.S. 819 (1976). To the same general effect, see Achong v. Comr., 246 F.2d 445 (9th Cir. 1957) and Gault v. Comr., 332 F.2d 94 (2d Cir. 1964). The result is less clear if both elements are not present, in other words if the taxpayer only has regular frequent and substantial sales, or only substantial development activities, is the taxpayer treated as a dealer? Despite the lack of clarity in the courts on this issue, we will presume for purposes of this assignment that substantial development activity is alone sufficient to trigger dealer status. While this may not literally be true, it is certainly clear that substantial development activity even in the absence of regular, frequent, or substantial sales would materially increase the taxpayer's risk of dealer status, and from the standpoint of advising a client in planning a transaction, substantial development activity should be avoided in order to maximize the client's prospects of investor treatment. Having said that, the issue becomes whether entering into a contract for development (with actual consummation of the contract being completed after the sale of the property) constitutes substantial development for this purpose. I was able to locate one case on point, Pontchartrain Park Homes, Inc. (1963), TC Memo 1963-92, PH TCM ¶63,092, aff'd (1965, CA5), 16 AFTR 2d 5535, 349 F2d 416, 65-2 USTC ¶9631. In this case the taxpayer, a developer, entered into an arrangement with the City of New Orleans to purchase and develop a large tract of land. The developer agreed to install a large, costly drainage system to serve not only the developer's property but also abutting property owned by the City. The development project was divided into several discrete phases. After the initial phases were completed, it was discovered that a smaller tract representing one of the later phases of the project had certain physical problems. Also, sales of lots to that time had been disappointing. Accordingly, the developer decided not to develop that smaller tract and sold the land in bulk to another party. The government contended that because the developer had a binding contractual obligation to install the drainage system with respect to this smaller tract, i.e. to substantially develop the tract, the sale should be a dealer sale, not an investor-type sale. The Tax Court ruled (and the Fifth Circuit affirmed that ruling) that the existence of the contract to develop did not per se control the character of the property sale. In other words, one must look to the totality of the facts and circumstance surrounding the taxpayer's behavior with respect to the subject property. On the surface, it would appear that the Pontchartrain Park decision is favorable. I believe that the case is good news-bad news. The good news is that the unconsummated contract does not per se trigger dealer status. The bad news is that we seem to be framing the issue to narrowly, and I strongly agree with that premise not just from the holding of the case but from my own considerable experience in this area as well. I believe that the proper question is whether JV, taking into consideration the totality of its actions with respect to this property, is acting in a manner consistent with that of a dealer or that of an investor. I respectfully submit that undertaking the construction of a highway off-ramp and related road system is a radical departure from what one would ordinarily expect from an investor and wholly consistent with the behavior one would expect from a developer, i.e., a dealer. I assume that this point is self evident both to you as well as your client. Given that an investor is expected to take a passive role in hopes that market forces over a period of time will "bless" the property with an accretion in value and given further that a dealer/developer plays an active role adding value to the property through development and sales activities, it seems to me extremely apparent that constructing a multi-million dollar highway exit and related road system is a dealer/developer type activity, not the activity of a passive investor. My view regarding dealer status in this matter is buttressed by the fact that JV plans to sell/assign the property and the inchoate highway contract to a related party (DC) for completion of the highway and ultimate subdivision and sale of lots. Clearly DC will be considered a dealer, and my personal view is the courts would not allow the taxpayers in this case to artificially bifurcate through use of related entities what is in effect an integrated transaction. Moreover, in at least one case, the courts have attributed the dealer activities of the related transferee entity back to the transferor. See Bramblett v. Commr., 960 Fed. 526 (5th Cir. 1992). Discussion: Collateral Issue |
