Securing capital gains on development property.

Real estate developers are constantly striving for ways to treat income from developed property as capital gain. As discussed in this item, case law exists to supports capital gain treatment on a portion of the income from these transactions, if structured properly.

Bramblett

In Bramblett, 960 F2d 526 (5th Cir. 1992), rev'g TC Memo 1990-296, several investors set up Mesquite East (ME), a partnership, to purchase raw land. The partnership's stated purpose was real estate investment. ME held the purchased land for several years before the partners decided to develop and sell it. They sought to maximize capital gain treatment.

To achieve this goal, the taxpayers created a corporation, Town East (TE), to develop and sell real property. TE's ownership was the same as ME's. ME sold parts of the raw land to TE in three separate sales. Before these sales were made, TE had already entered into an agreement to develop the land, then sell it to an outside party. ME made a fourth sale directly to a different party. The total consideration for the four sales was $1,645,685.

Subsequent to the above activity, potential purchasers began contacting ME about purchasing portions of the remaining property, which represented the bulk of the original investment. The taxpayers had intended to sell the remaining raw land in a single purchase, so as not to risk losing capital gain treatment.

ME obtained an independent appraisal of the remaining property. Based on this, it sold the remaining property to TE for $9.83 million, by giving TE two notes payable and treating the transaction as an installment sale.

At no time during the years in issue did ME hire brokers or attempt to advertise or sell any part of its property. ME did not maintain an office; none of its partners spent more than a minimal amount of time on its activities. ME did not subdivide, develop or improve any of its property.

ME considered the raw land a capital asset at the time of its sale to TE and, thus, reported the sale proceeds as capital gain, which the IRS contested.

Tax Court

The Tax Court agreed with the Service, for several reasons. The most critical reason was that it believed that ME's trade or business was the sale of land, whether conducted directly or indirectly through TE. Thus, it held the sale gain to be ordinary. The taxpayer appealed.

Fifth Circuit

The appellate court reversed the Tax Court's decision, determining that TE's activities could not be attributed to ME. In Brown, 448 F2d 514 (10th Cir. 1971), the Tenth Circuit concluded that a corporation's business is not ordinarily attributable to its shareholders. The Fifth Circuit also determined there was at least one major, independent business reason to form TE to develop and sell land--to insulate ME and its partners from unlimited liability from a multitude of sources. Further, there was no substantial evidence that the transactions were not at arm's length or that business and legal formalities were not observed. Finally, ME bought the real estate as an investment, hoping its value would appreciate. It bore the risk that the land might not appreciate. Thus, the Fifth Circuit held that the Tax Court erred in (1) attributing TE's activity to ME and (2) concluding that ME was in the business of selling land. The appellate court determined ME held the land as an investment and, thus, was entitled to capital gain treatment on the sale gain.

Agency: Another critical factor in the Tax Court's ruling was the belief that TE was acting as an agent on ME's behalf. Rejecting this, the Fifth Circuit noted that Nat'l Carbide, 336 US 422 (1949), and Bollinger, 485 US 340 (1988), set forth standards for determining when a corporation is an agent of its shareholders. In Nat'l Carbide, 336 US 422,437, the Supreme Court held that the fact that the subsidiaries were completely owned and controlled by a parent did not support the conclusion that they were the parent's agents.

Whether the corporation operates in the name and for the account of the principal, binds the principal by its actions, transmits money received to the principal, and whether the receipt of income is attributable to the services of the employees of the principal and to assets belonging to the principal are some of the relevant considerations in determining whether a true agency exists. If the corporation is a true agent, its relations with its principal must not be dependant upon the fact that it is owned by the principal, if such is the case. Its business purpose must be the carrying on of the normal duties of an agent.

The Fifth Circuit considered the factors mentioned above and concluded as follows: (1) there was no evidence that TE ever acted in the name of or for ME's account and (2) TE did not have authority to bind ME. TE did transfer money to ME, but it was based on the agreed-on fair market value of the property at the time of sale. TE realized a profit from its development that was much larger than a typical agency fee. TE's receipt of income was not attributable to ME's services or assets. The court thought it clear that TE was not carrying on the normal duties of an agent; it was not selling or developing the property on ME'S behalf, because TE retained all of the profit from development.

IRS Response

After Bramblett, the IRS released an information letter; see INFO 2002-0013. The letter did not question the classification of a sale of land to an identically owned development corporation in certain circumstances. However, the Service indicated it would continue to argue that an agency relationship exists between a seller entity and a related-purchaser entity. Thus, it is imperative that corporations follow the standards set forth in the above cases to discourage the IRS from attacking capital gain treatment.

Phelan 

A similar transaction was later challenged in Phelan, TC Memo 2004-206. The taxpayers cited Bramblett, but to no avail. In Phelan, a partnership was organized as a limited liability company (thus, it already had liability protection, so the business purpose in Bramblett (insulating ME and its partners from unlimited liabilities) did not apply). Only a portion of the land was sold by the partnership to a corporation; the Tax Court ruled that this provided a business purpose. The sale between the related entities kept the land that was not part of the sale excluded from any potential liabilities that arose from the portion of the sold land that was being developed. (For more details, see Sartain, Tax Clinic, "Capital Gains on Development Property," TTA, December 2004, p. 734.)

Planning Suggestions

Both Bramblett and Phelan can be used as planning techniques for developers. There are several things taxpayers can do to strengthen the argument that the transaction qualifies for capital gain treatment, including:

1. The partnership should include in its operating agreement that its purpose is real estate investment.

2. The partnership should not hire brokers or attempt to advertise or sell the property, maintain an office, spend significant time there, or subdivide, develop or improve any of the property before selling it.

3. The development company should be formed as a corporation, preferably an S corporation (while never litigated, it would appear that using an S corporation to purchase the land as an investment and a partnership to develop the land may work).

4. The land (or at least, a significant portion) must be held as an investment for at least one year.

5. The number of sales from the partnership to the corporation should be kept to a reasonable amount to ensure investment status.

6. The corporation should not act as an agent on the partnership's behalf.

7. The corporation must have a valid business purpose.

8. An independent valuation of the property should be completed before sale.

9. The corporation must develop the property independently, without the partnership's assistance or participation.

Major hurdles in trying to use Bramblett and Phelan to achieve capital gain treatment are holding the property for one year and having the property appreciate without developing it. One potential way to create appreciation is for the taxpayer to develop the property in sections or phases. For example, the partnership can sell 20% of the land to the corporation for development. The initial sale between the partnership and the corporation will be treated as short-term capital gain (i.e., ordinary income). Development of the property may greatly increase the value of the remaining undeveloped property.

Because the court ruled in Phelan that selling a portion of the land to a separate company to keep the remaining land free from potential liability arising from development is a valid business purpose, a taxpayer can use this argument to support the transaction's structure. The developer would not want to expose 100% of the land to liability during development; the developer seeks only to purchase and develop the land in pieces. The partnership still has the option to develop the property itself or to sell it to another party, ensuring investor status. This will allow for appreciation in subsequent sales of the land to the developer, ensuring capital gain treatment.

FROM JUSTIN DODGE, CPA, EHRHARDT KEEFE STEINER & HOTTMAN PC, DENVER, CO