Tax Court Limits Real Estate Developer's Losses; Rejects Penalty Assessment

(Parker Tax Publishing February 2018)

The Tax Court held that a individual who owned undeveloped land, sold custom built homes, and owned rental properties (1) had a capital, not ordinary, loss on the sale of property held for investment, (2) was entitled to deduct expenses as investment expenses under Code Sec. 212, and (3) was barred by the passive activity rules from deducting rental expenses because he did not materially participate in the business. However, the Tax Court determined that accuracy-related penalties did not apply because the taxpayer reasonably relied on his accountant to prepare his returns. Conner v. Comm'r, T.C. Memo. 2018-6.

Facts

Barry Conner was the owner and CEO of America's Home Place (AHP), an S corporation. AHP was a custom home builder operating in the eastern U.S. AHP did not own the lots where the homes were built and did not maintain an inventory. During 2012 and 2013, the years at issue, AHP's main source of revenue was from the sale of custom homes. In 2013, AHP made a charitable contribution by way of a bargain sale of undeveloped land to a church. Conner treated the land as investment property and deducted $520,000 based on the difference between the land's sale price and its fair market value.

Conner also owned several single member LLCs through which he acquired large tracts of undeveloped land before the years at issue. These entities were Shoreline, West Ahaluna, BC LLC, and Lumpkin. Shoreline bought 95 acres of undeveloped land in 2005. Conner intended to develop the land as a residential subdivision and prepared design plans with the help of an outside firm. However, Conner could not obtain credit due to the 2008 financial crisis and development stalled. In 2013, he put the land in a conservation program. Later that year, he sold it for around $1.5 million to an unrelated party. Conner was approached by the buyer and did not advertise the land for sale. Shoreline reported an ordinary loss in 2013 of $1.9 million.

West Ahaluna bought 176 acres of undeveloped land in 2004 on which Conner planned residential and commercial developments. He hired a design firm and a surveyor. The residential component did not progress past the planning stages; Conner instead focused on the commercial component. He later agreed to sell 100 acres to a commercial developer, but the deal fell through and the commercial component was not physically altered or improved. In 2012, Conner placed the land in a conservation program. West Ahaluna claimed interest and other expenses as business deductions.

BC LLC bought 83 acres of improved and unimproved land from 2004 to 2006. The improved portion included homes and a warehouse. In 2008 Conner engaged a developer to prepare residential development plans on 38 acres of the property. He applied for rezoning and annexation of part of the land but performed no further development activities. Conner bought the warehouse property in 2005 subject to a preexisting loan. When the loan was refinanced, BC LLC was listed as being in the investment real estate business. A renewal of the loan included a statement describing the property as investment property. BC LLC reported rental income and deducted interest and other expenses.

Lumpkin bought 353 acres of timberland subject to a conservation easement in 2005 with a bank loan. Lumpkin also acquired land that included two mobile homes subject to leases. Conner prepared design plans for part of the Lumpkin land but made no further development efforts. A 2011 appraisal noted that development was not financially feasible, and a 2012 appraisal concluded that the best use of the property was to be held as investment until the market improved. Conner reported rental income from Lumpkin and deducted interest and other expenses.

Conner also owned Gainesville Market LLC (GM), which owned a strip mall and had commercial tenants. GM had no employees. Administrative tasks were performed by employees of AHP. Keith Brown, an AHP employee, handled tenant issues and performed other duties, and GM paid AHP a management fee for his services. Conner performed some activities pertaining to GM, including reviewing expenses for recurring payments (e.g. taxes and utilities) and approving leases at set prices that did not involve negotiations. GM struggled with low occupancy rates and reported losses for the years at issue.

Conner has no tax background. He hired Brady Ware, an accounting firm, to prepare his tax returns. Thomas Marsh was the partner in charge of preparing Conner's returns. Marsh concluded that Conner was a real estate professional who materially participated in the activities of GM, BC LLC, and Lumpkin. Marsh therefore concluded that those LLCs should be reported on Schedule E, Supplemental Income and Loss. Marsh used Schedule C, Profit or Loss from Business, to report West Ahaluna and Shoreline. Marsh knew that Conner had not physically developed or excavated any of the BC LLC, Lumpkin, Shoreline or West Ahaluna properties.

IRS Arguments

The IRS determined deficiencies of $164,000 for 2012 and $681,000 for 2013. It argued that Shoreline's loss was capital, not ordinary, because the land was held for investment. The IRS allowed the LLCs' expenses not as business expenses but as investment expenses under Code Sec. 212. The IRS saw the LLCs as separate entities and not a single development plan that rose to the level of an active trade or business under Code Sec. 162. Conner's deduction for the GM, BC LLC, and Lumpkin losses were disallowed under the Code Sec. 469 passive activity loss rules. Regarding AHP's bargain sale, the IRS determined that the land was an ordinary asset and said the deduction was limited under Code Sec. 170(e) to the difference between the sale price and AHP's basis. The IRS also applied accuracy related penalties.

Taxpayer's Arguments

Conner challenged the deficiencies in the Tax Court. He argued that Shoreline sold land that it held in the ordinary course of business. He said the LLCs constituted a single, active development business because all of the land was to be developed as part of a master plan. Conner said his rental losses were not passive because he was a real estate professional who materially participated in the rental business. Regarding AHP's bargain sale, Conner said AHP held the land for investment so the Code Sec. 170(e) limitation should not apply. Finally, Conner argued that penalties should not apply because he reasonably relied on Brady Ware.

Tax Court's Analysis

The Tax Court held that the Shoreline sale resulted in an ordinary loss because Shoreline held the property for investment. The court reasoned that Shoreline had only one sale in eight years and Conner made no effort to sell the property. Conner did nothing to further the Shoreline development from 2007 to 2013 and, given the length of time the property sat idle, capital loss treatment applied.

The Tax Court held that the LLCs' expenses were deductible under Code Sec. 212 as investment expenses. The court found that none of the developments progressed beyond the exploratory or formative stage. Conner, the court noted, did not advertise or engage in regular sales activity and the LLCs had no day to day operating expenses. One property was listed in bank documents as investment property, and an appraisal for another concluded the best use of the land was holding for investment. The Tax Court rejected Conner's argument that the LLCs constituted a single development activity that rose to the level of an active trade or business under Code Sec. 162. In the court's view, the lack of sales or development activity showed that the LLCs held land for investment. Conner never subdivided or otherwise improved any of the properties. The court also did not agree that the activities of the LLCs, AHP and Conner individually were a single integrated business; it found that AHP, an S corporation, was a separate entity for tax purposes, and it did not attribute AHP's activities to the LLCs or to Conner.

The Tax Court held that Code Sec. 469 applied to the loss deductions for GM because Conner did not materially participate in it. The court found that Brown handled day to operations and that tenants knew him, not Conner, as the property manager. Conner failed to substantiate to the court's satisfaction that he spent more than 100 hours per year on GM's operations. Conner also did not materially participate under the facts and circumstances test because GM paid AHP for Brown's management services and Brown participated more than Conner in the operations. Conner also did not materially participate in the other LLCs' rental activities, the court found, because AHP handled administrative responsibilities for those properties and Conner did not show he participated more than anyone else in their activities.

The Tax Court found that Conner's deduction for AHP's bargain sale of property was not subject to the Code Sec. 170(e) limitation. AHP bought the land in 2005 and sold it to the church in 2013, so the court concluded that the land was held for investment and was not sold in the ordinary course of AHP's business.

Finally, the Tax Court concluded that Conner was not liable for penalties assessed by the IRS because he reasonably relied on Brady Ware. Marsh, a competent professional with real estate experience, decided which forms should be used, and Conner provided Marsh with all the necessary information to prepare the returns. Given the complexity of the returns, the court found that it was reasonable for Conner to rely on Marsh's expertise and advice.

For a discussion of the deductibility of expenses for real estate development, see Parker Tax ¶90,140.

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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