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Capital Gains Tax on Land Sale: Facts and Circumstances that Play a Crucial Role

One issue that has been heavily litigated in tax court is whether capital gains tax on land sale should be applicable. While the results of cases dealing with this issue have been wide-ranging and sometimes contradictory, it is clear that the specific facts and circumstances in each case play a crucial role in determining the outcome.

In order for a sale to result in a capital gain, the underlying asset must meet the definition of a capital asset. However, rather than providing a direct definition of a capital asset, the Internal Revenue Code defines the term by exclusion stating that an asset is not considered a capital asset if it is “held by the taxpayer primarily for the sale to customers in the ordinary course of the taxpayer’s trade or business.” (Section 1221(a)(1)).

Sugar Land Ranch Development, LLC v. Commissioner of Internal Revenue

One such case recently settled in the Fifth Circuit court was that of Sugar Land Ranch Development, LLC (“SLRD”). In this case, the Court ruled that the tracts of land in question were held by SLRD as investments and, therefore,  gains from the sales were treated as capital gains. While there are many factors to consider in such cases, it appears that the factor relied upon most heavily in the court’s decision was the frequency and substantiality of sales of property.

SLRD was established in 1998 with the principal purpose of acquiring contiguous tracts of land for development. In 1998, SLRD purchased a former oil field that was under development by related parties. The original plan was to clean up the site and subdivide it into residential units. SLRD spent 10 years beginning clean up, building a levee, and also entered into a development agreement with the City of Sugarland. Late in 2008, however, SLRD determined that the original development plan was not economically feasible given the crisis in the housing market. The decision not to move ahead with development was formalized in an official company document and member resolution. The land remained untouched until 2012, during which time no further attempts to develop or sell any portion of the land were made by SLRD.

In 2011, SLRD was approached by Taylor Morrison about purchasing 2 or 3 parcels collectively known as the TM parcels. In 2011, Taylor Morrison purchased TM-1 and, in 2012, he purchased TM-2 and TM-3. The 2012 contracts had consideration of one lump sum for the mostly undeveloped parcels. In addition, the contract on TM-2 contained a provision under which SLRD would receive 2% of the final sale price of each future home, accrued upon sale of the home. SLRD would also receive $3,500 and $2,000 for each plat recorded on TM-2 and TM-3, respectively. During 2012, the only payments made by Taylor Morrison to SLRD were the lump sum payments for the undeveloped land – there were no payments made on the 2% or per plat provisions.

The Court concluded that the gains from the sales of TM-2 and TM-3 were capital gains as the parcels were held for investment and not sold in the ordinary course of business.  This decision was based on several key facts and circumstances presented. First, the evidence showed that, in 2008, SLRD ceased to hold its property for the primary purpose of developing it for sale and, rather, held it as investment property. This was substantiated by the formal Company documents discussed previously. Second, SLRD did not develop or sell lots from this parcel of land or any other parcel beginning in 2008. The property in question was never subdivided for sale and the Company never spent any time marketing or seeking potential buyers. Third, subsequent to 2008, SLRD had infrequent sales, further supporting the conclusion that the sales in question were not within the ordinary course of SLRD’s business. Fourth, with the exception of land conveyed for public use, all of SLRD’s sales of undeveloped property subsequent to 2008 (in the area in question) were to either Taylor Morrison or related entities. The IRS attempted to make an argument that SLRD’s development activity outside of the area in question should be given consideration. The Court rejected this argument stating that the IRS had no legal authority or support for this position and that the parcels of land were clearly segregated by both an easement and levee.

In conclusion, it is important that a taxpayer consider all facts and circumstances of a land sale in order to determine the appropriate tax treatment. The SLRD case is just one example of how the determination will often come down to whether or not the fact pattern supports the taxpayer’s position that the property in question was held for investment and not for sale within the ordinary course of business.

For questions or more information, contact Rebecca or a member of our Real Estate Group by filling out the form below.

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