An interesting tax question arises when a taxpayer decides to sell land in bulk. To fully understand the issue, it is first necessary to describe the income tax strategy considered in such planning and the alternative treatments accorded an alternative finding by the Internal Revenue Service.
Depending on the particular facts and circumstances, land can either be properly characterized as inventory or, alternatively, as a capital asset (held for investment purposes). The sale of land can produce a significantly different tax liability depending upon the characterization of the land being sold. A sale of inventory produces ordinary income and any gain (profit) recognized on that sale would be subject to ordinary income tax rates, currently capping at 39.6 percent. A sale of a capital asset, on the other hand is subject to preferential capital gains tax rates, currently capping at twenty (20) percent. For obvious reasons, a fundamental strategy is to arrange affairs such that land being held for future use is characterized as a capital asset.
The circumstance where land is classified as inventory is most often associated with real estate developers. To accomplish development projects, most developers acquire larger land masses that are wholly undeveloped. After developing the land to meet building, zoning and municipal code requirements, the larger tract of land is very often rezoned and severed into smaller lots to be sold as stand alone units. This conversion of the larger tract into smaller lots is often the catalyst on which the Internal Revenue Service finds for characterization of the holdings as inventory. However, selling a substantial number of the lots on a “per lot” basis can also contribute to such a characterization.
In a recent United States Court of Appeals decision in the Eleventh Circuit, the facts and circumstances worked against the taxpayer/developer and resulted in paying the higher ordinary income tax rate on the sale of partially developed land. The case proves interesting because of the simplistic analysis applied by both the Internal Revenue Service and the Court.
In Boree, the taxpayer and a partner, doing business as Glen Forest, LLC (“Glen Forest”) purchased 1,892 acres of vacant real property in Baker County, Florida for residential development purposes. The total cost of the real property acquisition was $3.2 million, much of which was financed. After the county in which the property was located rezoned the property (i.e., sub-divided), the tract consisted of more than one hundred (100) lots. Glen Forest then sold approximately 15 ten-acre lots located around the property’s perimeter in 2003.
In February, 2003, the taxpayer executed a Declaration of Covenants, Conditions, and Restrictions for West Glen Estates (the chosen name of the housing development, itself) which, among other things, created a homeowners association. This document repeatedly referenced Glen Forest as the “developer” of West Glen Estates.
Through the remainder of 2003 and 2004, Glen Forest engaged in a series of other development activities but, importantly, did NOT install water lines, sewer lines, electrical lines, gas lines, telephone lines, cable lines or a storm drainage system. Nor did Glen Forest pave any roads, perform any grading work or landscaping or build any structures on the property. The Company also did NOT have a sales office nor did it hire a broker to sell lots. Occasionally, the company did some newspaper advertising. Each of these factors should have aided the taxpayers’ position that the raw land was being held as an investment.
Beginning in late 2004, the county later adopted a series of land and use restrictions that made the project, as planned, unprofitable. During 2004, Glen Forest sold 26 lots. In 2005, just eight lots were sold. In March of 2005, the taxpayer purchased his partner’s interest in Glen Forest. The taxpayer’s wife then became the second member of the limited liability company. Though Glen Forest attempted a number of alternative development strategies, none seemed to attain the status of viability and the taxpayer(s) decided to look at other means to sell the property.
In 2006, the taxpayers discovered that a successful Miami developer, Adrian Development, (“Adrian”), was planning a large-scale development on a parcel of property adjoining the West Glen Estates property. In a negotiated transaction, Adrian agreed to purchase nearly all of Glen Forest’s remaining unsold property in West Glen Estates (over 1,067 acres). The transaction closed in February, 2007. The taxpayer reported the gain of $8,578,636 as capital, even though they deducted $46,360 of development expenses as ordinary. (Note that substantial ordinary losses were taken in all earlier years for land carrying costs).
In 2011, the Internal Revenue Service issued a deficiency notice of $1,784,242. It further added a twenty (20) percent substantial underpayment penalty. The taxpayers filed in the Tax Court for reconsideration and abatement of the penalty.
The Tax Court held that the sale of all of the remaining lots in bulk generated ordinary income from the sale of inventory, noting that the taxpayers “consistently treated Glen Forest as a business” as opposed to an investment.
The Eleventh Circuit affirmed, concluding that the land was not a capital asset because the taxpayer held the property primarily for development, rather than investment, purposes. The Appellate Court did find that the Tax Court erred in the imposition of the penalty, ruling that the taxpayers acted with reasonable cause.
The formal opinion has a substantial amount of critical detail which can add color and detail to the Court’s assessment. Suffice to say, however, planning for transactions such as this one requires a careful and complete analysis and consideration of all attendant facts and circumstances. Slight variations in the course of these activities would seem to have offered the taxpayers a significantly greater chance of success upon Internal Revenue Service challenge.
Should you have a similar transaction, or if you have questions or comments, please call Bob Grossman or Don Johnston.
The court citation for the case is Gregory G. Boree, 118 AFTR 2d 2016-XXXX (CA 11).
