Originally published on Forbes.com May 16th, 2014
One of the more challenging questions in income taxation of real estate transactions is whether a taxpayer is a dealer or an investor.There is a simple way to resolve the issue. When you are running losses you are a dealer. When you have a big sale at a big gain you are an investor.Too bad that does not work so well. At least that type of thinking did not work out in the Tax Court’s recent decision in the case of Gregory and Melanie Boree.
The year at issue was 2007. During 2007 Glen Forest, LLC, which Mr. Boree had formed with David Dukes, sold 1,067 acres to Adrian Development for about $9.6 million. (In 2005 Mr. Boree became the sole owner of Glen Forest, LLC which would have converted it to a disregarded entity rather than a partnership.) The 2007 Form 1040 indicated that Mr. Boree’s occupation was “Real Estate Professional” and reported long-term capital gain of $8,578,636 relating to the Adrian transaction. The IRS seemed to have thought capital gain maybe not and issued a deficiency notice of $1,784,242. (That’s about the 20% swing you would expect) As is almost inevitable the IRS tacked on the 20% accuracy penalty moving the total tab above $2 million.
In order to evaluate the propriety of capital gains treatment, the Courts analysis went back to 2002 when Glen Forest LLC was formed and purchased 1,982 acres in Baker County, Florida. 280 acres was immediately sold to eight purchasers in order to reduce cost. Also in 2002 one 10 acre lot was sold. Lots were sold in subsequent years and development work commenced.
Glen Forest subsequently applied for, and received, exemptions from certain Baker County subdivision requirements. These exemptions allowed Glen Forest to sell lots without completing interior roads or submitting plats to the board. In 2003, Glen Forest executed a declaration of covenants, conditions and restrictions of West Glen Estates (declaration) and created a homeowners association to enforce the declaration and maintain the common area. The declaration defined, and consistently referred to Glen Forest as, “developer”. In addition, it provided Glen Forest the right to designate at least one member of the board of directors of the homeowners association if “Developer holds for sale in the ordinary course of business at least five percent (5%) of the acreage in all phases of the property.”
The Court also looked at Mr. Boree’s returns in the prior years.
On their Forms 1040, U.S. Individual Income Tax Return, relating to 2005, 2006, and 2007, petitioners reported adjusted gross income of $2,322,652, $6,252,475, and $8,290,706, respectively. Petitioners indicated on their Schedules C, Profit or Loss From Business, relating to these years that Mr. Boree’s “Principal business or profession” was “Land Investor]”. In addition, petitioners reported income from Glen Forest’s sales of lots in 2005 and 2006 as ordinary income and deducted expenses relating to the GF property, claiming cumulative net losses of over $200,000. On their 2007 Form 1040 petitioners indicated that Mr. Boree’s occupation was “Real Estate Professional” and reported long-term capital gain of $8,578,636 relating to the Adrian transaction
The Decision
The Court enumerated the many ways in which Mr. Boree was not acting as an investor and denied capital gains treatment.
Prior to the Adrian transaction, petitioners engaged in real estate development activities. Mr. Boree’s testimony to the contrary was not credible and was convincingly contradicted by the documentary evidence. Petitioners consistently treated Glen Forest as a real estate business and represented it as such to buyers of GF property, the board, and on their 2005, 2006, and 2007 tax returns. Glen Forest subdivided the GF property, built a road, spent significant time and money on zoning activities, and continued to pursue development activities after the board adopted the moratoriums and requirements. Moreover, between 2002 and 2006, petitioners sold approximately 60 lots comprising approximately 600 acres of the GF property. Such sales, made to customers in the ordinary course of business, were frequent and substantial. Indeed, petitioners’ actions from the time Glen Forest acquired the GF property, through the date of the Adrian transaction, reflect their intent to develop the GF property and sell subdivided lots to customers. Petitioners’ intent did not change when they became the sole owners of Glen Forest in 2005. To the contrary, petitioners continued to engage in significant sales and development activities; reported their sales of lots in that year as ordinary income; deducted, rather than capitalized, expenses relating to their real estate activities; and did not segregate the property sold to Adrian Development from the rest of the GF property.
Not surprisingly the accuracy penalty was upheld.
Was This Case Winnable?
I’m just a lowly CPA, but I think a critical point was missed in the decision. The Court attributes everything that happened from 2002 on to Mr. Boree. If Glen Falls LLC was a partnership up till 2005, what happened before then was not relevant. Mr. Boree gets a fresh start in his purpose in holding the property at the deemed liquidation of the partnership. By conflating the two, the Tax Court appears to be contradicting its holding in the Phelan decision. Of course, it appears that Mr. Boree did not really take advantage of the fresh start. Nonetheless, I think that more careful planning and the introduction of one or more special-purpose entities might have enabled Mr. Boree to achieve capital gains treatment on a significant part of the transaction.
You can follow me on twitter @peterreillycpa.
Note
Several years ago I wrote about the way in which the Phelan decision is a model for how to get capital gains treatment while engaging in development activity. I have made that article available here.