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Submitted By: National retail chain

Subject: Unwanted property as capital asset

Date/Time: Wed Dec. 18 15:55:23 EDT 2002

FACTS

In order to acquire a desired store site, the taxpayer was required to obtain a second site for which it had no use. It immediately attempted to sell the second site, but more than a year has passed without finding a suitable buyer.

QUESTION

May the taxpayer claim a long-term capital gain on the sale of the property even though it always intended to sell the second site?

CONCLUSION

The taxpayer may claim a long-term capital gain on the sale of the unwanted property. Although not articulated by the courts or commentators, there seems to be a latent rule of law that at the time a taxpayer acquires excess unwanted property incident to the acquisition of desired property, the excess property is generally investment property. This is true even where the taxpayer is otherwise in the business of selling real estate to customers in the ordinary course of business. Whether the property remains a capital asset at the time of ultimate sale is an issue that is decided under the general principles distinguishing dealer from non-dealer property. However, the taxpayer does seem to have a leg up in that it is starting from the presumption that the property was initially an investment property.

ANALYSIS

While seemingly not recognized as a tax doctrine unto itself, there are quite a few cases scattered throughout the law which support the proposition that excess property which a taxpayer obtains as a prerequisite to obtaining a targeted property will often be treated as a capital asset. The cases are scattered because for the most part they don't even cross-reference each other and rely on the traditional analysis to make the dealer/non-dealer determination. This traditional analysis looks at factors such as the purpose for the acquisition, continuity, number and frequency of sales, degree of sales activities, length of holding period, and substantiality of income. However, the cases are fairly consistent in their application despite the lack of anything linking them together.

Interestingly, most of the case law arises in the context of taxpayers who were admittedly dealers in real estate. This is a little surprising since, where the target property is ordinary income dealer property, the taxpayer would seem to have an uphill fight in attempt to obtain capital gains for property purchased in connection with its ordinary income activity. If there were a lead case in the area, it would probably be Eline Realty Co., 35 TO 1 (1960). In this case, the taxpayer, a longtime real estate developer, acquired a 16-acre parcel for development. As he developed the property and put in roads, he ended up with a portion of the property of a little more than half an acre that was oddly shaped and cut off from the rest of the development. The Tax Court held the taxpayer was entitled to capital gain, since the unsuitability of the parcel for his development turned it into property held primarily for speculation and investment, and not property for sale to customers in the ordinary course of business.

In Charles Mieg, 32 TC 1314 (1959), the taxpayer purchased a parcel for development, which included the backside of a mountain having no road access. At the time the property was acquired, it was considered useless and to be of minimal value. However, several years later, a country club was developed near the useless property, and the owners purchased the taxpayer's property. With little discussion, the court held that the property was not held for sale to customers.

In Elmer Toll, 20 TCM 1548 (1961), the taxpayer purchased two blocks of property to build FHA/VA financed property. Such property could not be built on one of the blocks, but the taxpayer was forced to buy both to get the one he wanted. Developing the one block, he left the second block vacant. He subsequently received an unsolicited offer for the second block, and claimed capital gain on the sale. The Tax Court upheld the taxpayer, despite the fact that he had listed the second block as inventory property on his tax return.

In Carl Metz, 14 TCM 1166 (1955), taxpayer developer was forced to purchase low-lying property that would need to be filled, along with other property he wanted to develop. He only purchased the entire property after his broker waived his commission, and ended up building only on the solid portion. The taxpayer then sold the remainder of the low-lying property, and the Tax Court held that the property was investment property.

There are also cases dealing with excess property arising outside of the real estate dealer context. In M. S. Doss v. United States, 54-1 USTC 9413 (D.C. Texas), the taxpayer had leased ranch land for over 30 years, when the landlord decided to sell the property. The taxpayer had only leased nine sections, but the landlord was only willing to sell its entire holding of 65 sections. The taxpayer ended up buying all 65 sections, but as word spread of the taxpayer's purchase, he received numerous offers for other sections. Consequently, in the course of the ensuing two years, the taxpayer engaged in over 40 sale transactions. Nevertheless, the court held the taxpayer was entitled to capital gains.

In J. O. Chapman, 3 TCM 604 (1944), the taxpayer purchased property for the purpose of dedicating a portion of the property to the government so the taxpayer could get a much needed road built to its property. In this case, the excess property was not forced on the taxpayer, but rather he purchased it as a smokescreen to obscure the fact that he was attempting to get the road built. Upon the subsequent sale of the remaining property, the portion that the taxpayer did not subdivide produced capital gain.

In Hebenstreit v. United States, 55-2 USTC 9571 (D.C.N. Mex.), two taxpayers wanted to purchase land to build personal residences. The seller refused to sell just the residence sites and would only sell an entire 104-acre tract, which was largely swampland. The taxpayers purchased the tract, with the intent of selling off the excess not used for personal residence purposes. However, the taxpayers always intended that any sales of excess property would only be to purchasers who would use the property consistent with the taxpayers' own personal use of their property. Shortly after purchasing the tract, the taxpayers drained the swampland and subdivided the property. About a third of the property was deeded without cost to a nearby country club. Over the next 20 years, another third of the property (87 lots) was sold to individual purchasers. These sales were motivated by the desire of the taxpayers to minimize the cost of their own home sites. The court ruled that the lots in question were capital assets in the hands of the taxpayers.

Prepared by: David Chan

David Chan, a principal with Ernst & Young, has 27 years experience in real estate law. He is widely published in real estate periodicals. David received a BA in Economics, an MS in Business Administration, and a JD from UCLA. He is a member of the Southern California Chinese Lawyers Association, the AICPA, the California Society of Certified Public Accountants, and the Asian Business League.

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Publication:Tax Executive
Date:Nov 1, 2002
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