Change of Intent Does Not Transform Gain on Property's Sale to Capital Gain.
(Parker Tax Publishing June 10, 2014)

The fact that a property owner's intent with respect to property he purchased changed did not transform gain on the later sale of the property from ordinary income into capital gain. Allen v. U.S., 2014 PTC 254 (N.D. Calif. 5/28/14).

Frederic Allen purchased a plot of land in East Palo Alto, California, in 1987 with the intention of developing the land. Over the following several years, Fredrick and his wife, Phyllis, expended significant efforts to develop the land. They purchased engineering plans and took out a second mortgage to finance the project. Additionally, Fredrick's own development company created ten development plans for the property and sought investors and partners to aid in the work. In 1999, the couple entered into an agreement with Clarum Corporation whereby they sold the property for a lump sum and percentage of the profit made on units sold on the property. Fredrick's firm also conducted some civil engineering work on the property until Clarum changed the nature of the development. In 2004, the Allens received a final installment payment from Clarum of $63,662 along with a 1099-MISC for the amount. The Allens characterized the $63,662 payment as capital gain while the IRS said it was ordinary income.

A district court held for the IRS, concluding that capital gain treatment was not correct because it was clear the Allens purchased and held the property for development. Thus, the property was not investment property eligible for capital gain treatment. In evaluating whether the property was a capital asset, the court looked at the factors enumerated in Austin v. Comm'r, 263 F.2d 460 (9th Cir. 1959), which include:

1. the nature of the property's acquisition;

2. the frequency and continuity of sales over time;

3. the nature and extent of the taxpayer's business;

4. the seller's activity regarding the property; and

5. the extent and substantiality of the transactions.

The court noted that although some attention is given to the reason for a property's purchase, particular weight is given to the purpose for which the property was held. In reviewing the factors, the court was greatly influenced by evidence demonstrating that the Allens intended to develop the property when it was purchased and took serious steps to develop the land while they owned it.

Thus, the first and forth factors, the court held, were determinative in this case because Fredrick admittedly purchased the property for development. Even though Fredrick testified that his intention to develop the property changed to an objective to sell the property because he did not have the requisite expertise to develop it, the court was not persuaded because Fredrick provided no support to explain how or when his goals with respect to the property changed.

This case highlights a recurring issue for taxpayers where property is initially purchased for residential or commercial development, but a downturn in the market results in the property being sold. As the court noted, these situations are very fact specific and a court's interpretation or weighing of factors similar to those in Austin will determine in each case if the property gets capital gain or ordinary income treatment.

As one example, in Graves v. Comm'r, Liberty Properties bought a piece of land and entered into a joint venture with Graves Construction Company ("Graves") for development. 867 F.2d 199 (1989). The joint venture divided up the property in four separate plots, to be developed as one major project. One plot was developed with sixteen units, but the others were only improved with infrastructure. The joint venture terminated with the sale of the underdevelopment properties to Graves, later entering into a partnership with another investor. Thereafter, the partnership continued to develop the plots according to the same plans Liberty Properties had intended to develop. Units on the developed properties were later sold. The partnership eventually terminated with Graves holding and then selling his interest in the remaining underdeveloped property, treating the sale as capital gain.

The IRS and Tax Court determined that the sale of the underdeveloped property resulted in ordinary gain because like the three other parcels, the property at issue was held for development purposes. The Fourth Circuit reviewed a number of factors including those from Austin and adding three others: the nature and extent of the taxpayer's business; the extent of advertising; and listing of the property for sale directly or through a broker. The court agreed with the Tax Court holding that the parcel sold was closely linked with the other parcels. Significantly, the appellate court found that even if perhaps the initial purchase and holding of one parcel was primarily for investment, while others were intended to be held for development, the taxpayer had not overcome his heavy burden showing that each parcel was held for different purposes. The lack of development activity on a single parcel that was part of a broader development plan does not, by itself, lead to the conclusion it was not intended for development. The court noted that intent with which to hold property can change, but the facts in the case did not prove a primary purpose other than development.

Moreover, in the consolidated case of Pool v. Comm'r, T.C. Memo. 2014-3, individuals purchased a large plot of land, contracted with a development company who was given a right to purchase, and took significant steps to prepare the subdivided parcels for sale, including entering into many buy-sell agreements at a fixed price. The sale of portions of the property resulted in ordinary gain, according to the IRS. The Tax Court noted the heavy burden on taxpayers and the factual nature of determining the character of income. The court reviewed the Austin factors holding that the taxpayers did not sufficiently support their position that they held the property for investment, but instead were sellers of real property. In its analysis, the court stated that the property owners' purpose for holding the property is the ultimate question and evidence suggests the land was held to develop and sell to customers. The court noted that taxpayers can change their intention after purchasing property, but in this case there was no support for this contention. The court also made mention to a "mosaic of plans" approach to determining the "nature and extent" Austin factor. Indirect elements are factors to be considered, the court stated, particularly where improvements are not made directly to the land, but provide an overall benefit to the property. Thus, the court concluded that the taxpayers could not substantiate the burden of proving an investment purpose treatment of the land and ordinary income treatment was correctly afforded.

The factual difficulty in a post hoc argument that property was held for a different purpose is evident in Allen, Graves, and Pool. Where taxpayers attempt to develop property, but receive a better deal by selling the land, the IRS and the Tax Court have been suspicious in accepting that property was always held for investment. The consequence of the high burden for the taxpayer results in courts finding certain factors for the IRS simply because the taxpayer inadequately supports his/her argument. For practitioners with clients facing similar issues, it will be important to develop a sound factual basis to demonstrate to the IRS and court that the property was held for investment. As in the recent Pool case, courts might imply the importance of certain facts through a mosaic approach if the evidence is indeterminate. Lastly, if the initial intention was to develop and sell the property and now the taxpayer seeks to argue for capital asset treatment, an indisputable display of how, when, and why intent changed will be necessary.

For a discussion of assets that qualify for capital gain treatment, see Parker Tax ¶111,105. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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