Few industries are as driven by tax laws as the real estate industry. Just listen to the uproar when a Washington lawmaker proposes to eliminate the mortgage deduction. Over the past year, though, taxes have not been in the real estate news as much as in the prior few years. There was one case, however, that was decided in California and slipped under the radar. This case is Allen et al. v. United States and it could have a significant impact on many real estate professionals.
One of the major planning issues encountered in RBZ’s real estate tax practice is preservation of the capital nature of real estate assets, which eventually leads to recognition of capital gains on disposition. This is not as straightforward as it appears. It is clear that if anyone acquired an apartment building, rented it for 20 years then sold it, the income recognized on the sale would be subject to capital gain rates. It is also clear that if a home builder acquired an undivided parcel, subdivided it, then built houses and sold them to individual homeowners, the income realized in this instance would be taxed at ordinary rates.
However, what if someone bought a parcel, took it through an entitlement process to subdivide the property and sold it at a profit in blocks to three different home builders, without ever physically altering the property? What is the character of this income? Is it a capital gain, since our taxpayer never intended to actually develop the property and all of his efforts were directed to preserve his investment and increase the value of the underlying capital asset? Or, is it ordinary income, since the taxpayer has been a home builder in the past, and spent significant effort in getting entitlements and ultimately sold it to multiple buyers? The taxpayer would likely argue the former and IRS would argue the latter. But which side is likely to prevail?
There is no fixed formula in deciding. Such was the situation for Frederic Allen, whose case was decided by a District Court in California last year.
Mr. Allen purchased a property in 1987 and for eight years attempted to develop it on his own, spending money on engineering plans and taking out a second mortgage. As a civil engineer, he developed approximately ten sets of plans for the property while going through the process of finding partners. Concluding that developing the property was beyond his means and expertise, he eventually found a buyer who could complete development, Clarum Corporation. They paid a lump sum to clear the title with a promise to also pay Allen a set fee each time a developed unit was sold. In 2004, Allen received a final payment from Clarum, which he treated as capital gain. The IRS, needless to say, thought differently.
After a lengthy trial, the district court found for the IRS, citing five primary factors:
1. The nature of the acquisition of the property
2. The frequency and continuity of sales over an extended period
3. The nature and the extent of the taxpayer’s business
4. The activity of the seller with respect to the property
5. The extent and substantiality of the transactions
The Court recognized that “it is the dominant purpose of the holding during the period prior to the sale which is critical.” It placed a significant weight on the fact that Allen was active with respect to the property as he was developing the engineering plans and, up until his sale to Clarum, was searching for development partners. Furthermore, the Court determined that the amount of time Allen spent trying to develop the property was significant and pointed out that even though the project may not have been Allen’s main occupation throughout the ownership of the property, it appears to have required substantial time, attention, and effort.
Even though infrequent sales are generally indicative of real property held for investment, the Court decided that the fact that Allen purchased only one property for development (or as investment) is not determinative and concluded that the profit realized on a sale was a result of taxpayer’s efforts, not for the mere passage of time.
Allen argued that because he purchased investment property only once and eventually sold it once, the transaction could not amount to a sale “in the ordinary course of the taxpayer’s trade or business.” But the Court noted that, while the extent and substantiality factor might slightly favor Allen because there was only one main sale transaction, it is neutralized since the transaction came after Allen had failed in his efforts to develop the property himself or find a developer to partner with him on this project.
This argument raises issues. By that logic, a real estate professional who owns and operates an apartment building and increases its value by changing the mix of tenants, upgrading the units and beautifying the landscaping should also recognize ordinary income on the sale of this building, since the taxpayer’s efforts resulted in an increase in value of the property and such efforts continued up to date of sale.
Whether you agree or disagree with the Court’s logic and its application of longstanding case law, the fact is, this is a new precedent and another arrow in the IRS’s quiver in its attempts at income recharacterization. Real estate professionals should be thoughtful in structuring their deals to distinguish their fact pattern from that presented in Allen.