In Sugar Land Ranch Development LLC et al. v. Commissioner, T.C. Memo 2018-21, the Tax Court determined that gain and loss recognized by a taxpayer from the sale of two large parcels of land were properly characterized as capital gain and loss, as contrasted with ordinary income and loss.

Facts

In 1998 Sugar Land Ranch Development, LLC (SLRD) purchased approximately 950 acres of land that it intended to develop into single-family residential building lots and commercial tracts for sale. As the land had previously been an oil field, SLRD performed some environmental cleanup between 1998 and 2008, which included capping oil wells, removing oil gathering lines and building a levee. SLRD also entered into a development agreement with the local city, outlining rules for development. The property adjoining the land was owned by a related-party developer.

Between 1998 and 2008, SLRD sold small portions of the land, reducing the property to 825 acres that were divided by road, utility and levee easements.

Late in 2008, the managers of SLRD decided not to attempt to subdivide or otherwise develop the property. They believed that SLRD would be unable to develop, subdivide, and sell residential and commercial lots from the property because of the effects of the subprime mortgage crisis on the local housing market and the scarcity or unavailability of financing for housing projects in the wake of the financial crisis. Instead, the managers decided that SLRD would hold the property as an investment until the market recovered enough to sell it off. These decisions were memorialized in a "Unanimous Consent" document dated December 16, 2008, as well as in an SLRD member resolution adopted on November 19, 2009, to further clarify SLRD's policy.

Between 2008 and 2012, the parcels "just sat there"; that is, SLRD did not develop the parcels in any way, or list the parcels with any brokers or otherwise market the parcels for sale.

In 2011 and 2012, Taylor Morrison purchased three parcels amounting to 580 acres, the TM-1, TM-2 and TM-3 parcels (collectively, the TM parcels). While not at issue in this case, the sale contract for the TM-1 and TM-2 parcels obligated Taylor Morrison to pay not only a lump sum sales price, but also to pay SLRD 2% of the final sale price of each future home eventually developed and sold out of the TM-2 parcel as well as $3,500 and $2,000 for each plat recorded on TM-2 and TM-3 parcels, respectively. The net gain at issue in this case is only the lump-sum payments SLRD received in 2012 for the largely undeveloped TM-2 and TM-3 parcels.

After sale of the TM parcels, SLRD exited the property by conveying a small amount to the City (for no compensation) and selling the remaining property to related parties in four sales in 2012, 2013, 2014 and 2016.

SLRD's 2005, 2006 and 2012 Forms 1065, U.S. Return of Partnership Income, list SLRD's principal business activity as "Development" and a principal product or service as "Real Estate". On its 2012 Form 1065, SLRD reported an $11,086,640 capital gain from its sale of the TM-2 parcel and a $1,569,393 capital loss from its sale of the TM-3 parcel.

The IRS issued a notice of final partnership administrative adjustment characterizing the net gains from SLRD's sales of the TM-2 parcel and TM-3 parcel as ordinary income rather than capital gains.

Law and analysis

Property that is "held primarily for sale to customers in the ordinary course of the taxpayer's trade or business" is excluded from the definition of a "capital asset" under Section 1221(a)(1) and excluded from "Section 1231 gain" treatment under Section 1231(b)(1)(B).

The determination of whether property is held primarily for sale to customers in the ordinary course of a taxpayer's trade or business is a factual determination that must be made based on an analysis of all the surrounding facts and circumstances. In Malat v. Riddell, 383, U.S. 569, 572 (1966), the Supreme Court defined "primarily" as meaning "principally" or "of first importance."

The Court of Appeals for the Fifth Circuit - the court to which this case is appealable, has held that the three principal questions to be considered in deciding whether gain is capital in character are: (1) "Was taxpayer engaged in a trade or business, and, if so, what business?" (2) "Was taxpayer holding the property primarily for sale in that business?" [and] (3) "Were the sales contemplated by taxpayer 'ordinary' in the course of that business?" Suburban Realty Co. v. United States, 615 F.2d 171, 178 (5th Cir. 1980).

The Court of Appeals for the Fifth Circuit has also indicated that various factors may be relevant to these inquiries, including:

— "The frequency and substantiality of sales of property
— The taxpayer's purpose in acquiring the property and the duration of ownership
— The purpose for which the property was subsequently held
— The extent of developing and improving the property to increase the sales revenue
— The use of a business office for the sale of property
— The extent to which the taxpayer used advertising, promotion, or other activities to increase sales
— The time and effort the taxpayer habitually devoted to the sales"

The parties agreed that SLRD was formed to engage in real estate development- specially, to acquire the property and develop it into single-family residential building lots and commercial tracts for sale. The Court held, however, that the evidence showed that SLRD ceased to hold its property primarily for sale in that business in 2008 and began to hold it only for investment. Further, the property was not developed any further and the IRS conceded that SLRD never subdivided the property.

Additionally, the TM parcels were not sold in the ordinary course of SLRD's business as SLRD did not market the parcels by advertising or other promotional activities, solicit purchasers or devote any time or effort to selling the property. Taylor Morrison approached SLRD to inquire about a sale. The sale of the TM-2 and TM-3 parcels was essentially a bulk sale of a single, large, and contiguous tract of land to a single seller, which was not a frequent occurrence in SLRD's ordinary business.

Because the TM-2 and TM-3 parcels were held for investment and were not sold as part of the ordinary course of SLRD's business, the Court held that the net gains from the sales of TM-2 and TM-3 parcels were capital in character.

Implications

The determination of whether gain from the disposition of real property is capital gain versus ordinary income is a facts-and-circumstances determination. Essentially, each case must be decided on its own facts, and it is often times difficult to reconcile decisions by the various courts. Sugar Land Ranch Development is an important case because it involves a situation in which a taxpayer was able to adequately establish for the court that its initial "primarily for development and sale" holding purpose in regards to real property was abandoned and replaced with a "primarily for investment" holding purpose.

As a comparison, see Victor Fargo, et ux., et al. v. Commissioner, T.C. Memo 2015-96 (Tax Alert 2015-1077), in which a taxpayer was not able to overcome the evidentiary burden that its initial purpose of acquiring a 2.2 acre tract of land (with a rental building thereon) for redevelopment into an apartment complex and retail space for resale was abandoned and replaced with a "primarily for investment" holding purpose. Although the taxpayer in Victor Fargo held the property for over 10 years before selling (without ever physically redeveloping the property into an apartment complex and retail space), the Court concluded that the taxpayer never abandoned its development plan for the property, as evidenced by multiple attempts to obtain financing to develop the property and by substantial expenses the taxpayer incurred for architectural, engineering and appraisal, permits and licensing fees.

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