Who is the developer?

If a taxpayer owns a tract of land and holds it for investment, any gain will be capital gain taxed at the lower capital gain rate.

If the taxpayer decides that he can make more money by subdividing the land and selling parcels or lots, the gain will be taxed at ordinary income rates. At that point, the development and sales activities mean the taxpayer is in the business of selling real estate rather than acting as an investor, i.e., he is a dealer.

A recent Fifth Circuit decision shows a taxpayer how he can have his cake and eat it too (Bramblett, 5th Cir., 1992, rev'g TC Memo 1990-296). In this case, a partnership was allowed to subdivide the land and obtain capital gains on most of the profit.

The taxpayer formed a corporation wholly owned by the partners of the partnership, selling the land to the corporation at its fair market value (FMV), and letting the corporation subdivide the land.

Thus, the gain on the taxpayer's sale of the land to the corporation was a capital gain; the gain on the sale of the lots by the corporation was ordinary income - but the corporation had a stepped-up basis equal to the land's FMV.

The IRS tried to attack this plan under at least three different arguments. First, it claimed the partnership was also in the business of selling land. Second, the Service argued that the corporation was an agent of the partnership so that the corporation's activities were attributable to the partnership. Third, it maintained that the form of the transaction was to be ignored and that, in substance, the partnership was the developer.

These arguments had been accepted by the Tax Court. However, the Court of Appeals reversed the Tax Court's decision and ruled in favor of the taxpayer.

There is a thin line between a capital transaction and an ordinary transaction in connection with the sale of real estate as evidenced by a somewhat humorous opening statement in the Fifth Circuit's decision in Byram, 705 F2d 1418 (5th Cir. 1983):

If a client asks you in any but an extreme case whether, in your opinion, his sale will result in capital gain, your answer should probably be, |I don't know, and no one else in town can tell you.'

The taxpayer lost at the Tax Court level in Bramblett and had to appeal to the Fifth Circuit. Thus, taxpayers should expect an IRS challenge if they take this approach.

Do not be too greedy in setting the sales price to the corporation: the corporation should make some profit from its development activities.