Developer required to capitalize real estate taxes.

• Author: Schuth, Michael R.

The Tax Court recently held, in John. J. Reichel, 112 TC No. 2, that a taxpayer was required to capitalize real estate taxes paid on properties he intended to, but did not actually, develop. The court rejected the taxpayer's argument that he was not required to capitalize the costs, because he took no positive steps to begin producing the property.

The taxpayer (a sole proprietor) had been a real estate developer since 1989. His business consisted of buying and developing raw land, including: applying for and obtaining zoning variances, grading plans, street plans, water plans, sewer and storm drain plans, site plans, architectural plans, environmental feasibility studies and development and construction cost estimates. He then subdivided the land and sold it to homebuilders. In 1991, the taxpayer bought two parcels of land with the intention of developing them. However, he never began any "development" activities, citing adverse economic conditions. He continued to hold the parcels for development.

In 1993, the IRS disallowed the taxpayer's deduction of real estate taxes on these parcels of land on Schedule C of his tax return. The Service claimed that the taxpayer was required to capitalize all real estate taxes on the property under Sec. 263A(a)(2)(B), and that the taxpayer was a "producer" with respect to the parcels under Sec. 263A(b)(1). The IRS noted that Sec. 263A(g)(1) specifies the term "produce" to mean, among other things, "develop."

The taxpayer argued that Sec. 263A(a)(2) (B) did not require him to capitalize the real estate taxes until he undertook positive steps to begin developing the parcel, contending that the court's earlier decision in Von-Lusk, 104 TC 207 (1995), established the principle that some activity had to occur for production of the property to begin. Because the taxpayer had not undertaken any development activities on the parcels, he claimed he never began producing them within the meaning of Sec. 263A and, therefore, did not need to capitalize the real estate taxes.

The court responded to the taxpayer's argument by referring to Regs. Sec. 263A-2(a)(3)(ii), which states that, if property is held for future production, taxpayers must capitalize direct and indirect costs allocable to such property, even though production has not begun. If property is not held for future production, indirect costs incurred prior to the production period must be allocated to the property and capitalized if, at the time the costs...