Partnership Did Not Hold Land for Development, Nor Sell It in the Ordinary Course of Its Trade or Business, So Gain Was Capital

In the case of Sugar Land Ranch Development LLC et al. v. Commissioner, TC Memo 2018-21, the IRS challenged the taxpayer’s treatment of gain from the sale of land.  The taxpayer had treated the gain as capital gain from the sale of investment property.  But the IRS argued that the property was held for sale to customers in the ordinary course of business and that the gain should be treated as ordinary gain.

To qualify for capital gain treatment, the gain must arise from the sale of an asset that is a capital asset in the hands of the taxpayer.  What is a capital asset is defined, under the IRC, by what is not a capital asset.  All assets held by a taxpayer are capital assets unless one of the exclusions, found at IRC §1221(a), applies.

In this case, the IRS argued the exclusion found at IRC §1221(a)(1) applied to the land held by the taxpayer.  That provision provides that capital assets do not include:

(1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;…

The taxpayer had acquired the property in 1998 with the intention of developing the land into single family residential building lots and commercial building lots.  The land was located in Sugar Land, Texas, just outside of Houston.  But events did not go as the partnership had hoped, and the Court noted the following change of course by the taxpayer:

Late in 2008 the managers of SLRD — Larry Johnson and Lawrence Wong — decided that SLRD would not attempt to subdivide or otherwise develop the property it held. From their long experience in the real estate development business, 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, Messrs. Johnson and Wong 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 (signed by Messrs. Johnson and Wong), as well as in an SLRD member resolution adopted on November 19, 2009, to further clarify SLRD's policy.

Between 2008 and 2012 the TM parcels “just sat there” (as Mr. Johnson credibly testified); that is, SLRD did not develop those parcels in any way. SLRD did not list the TM parcels with any brokers or otherwise market the parcels because SLRD's managers believed that there was no market for large tracts of land on account of the subprime mortgage crisis.

The partnership was eventually approached by a buyer for a portion of the land the partnership held, which the partnership agreed to sell.  The taxpayer reported the gain on the sale of the property to this buyer as capital gain.

The Court noted that, since any appeal of the case would go to the Fifth Circuit Court of Appeals, that Circuit’s standard for testing whether a gain is capital in case like this involves three key questions:

  • Was taxpayer engaged in a trade or business, and, if so, what business?
  • Was taxpayer holding the property primarily for sale in that business? and
  • Were the sales contemplated by taxpayer ‘ordinary’ in the course of that business?

The Tax Court did not accept the IRS’s view that the sale of property should be treated as ordinary income.  While the partnership was formed in 1998 to develop the property, a situation that would have culminated in recognition of ordinary income when the property was sold, the Court goes on to note the following:

But the evidence also clearly shows that in 2008 SLRD ceased to hold its property primarily for sale in that business and began to hold it only for investment. SLRD's partners decided not to develop the property any further, and they decided not to sell lots from those parcels. This conclusion is supported by the highly credible testimony of Messrs. Johnson and Wong and by the 2008 unanimous consent and the 2009 member resolution. In fact, from 2008 on SLRD did not develop or sell lots from those parcels (and the evidence does not suggest that SLRD ever sold even a single residential or commercial lot to a customer at any point in its existence). Respondent concedes that SLRD never subdivided the property.

More particularly, when the TM parcels were sold, they were not sold in the ordinary course of SLRD's business: SLRD did not market the parcels by advertising or other promotional activities. SLRD did not solicit purchasers for the TM parcels, nor does any evidence suggest that SLRD's managers or members devoted any time or effort to selling the property; Taylor Morrison approached SLRD. Most importantly, sale of the TM parcels was essentially a bulk sale of a single, large, and contiguous tract of land (which was clearly separated from any other properties by the HLP easement and the levee) to a single seller — clearly not a frequent occurrence in SLRD's ordinary business.

In many ways, it’s a bit surprising the IRS decided to take this case as far it has given the facts in the case, but it serves to illustrate how hard it seems to be to convince the IRS that a taxpayer has really changed the reason for holding a piece of property that was initially acquired for development.