Federal Taxation
| Citation | Vol. 66 No. 4 |
| Publication year | 2015 |
Federal Taxation
Robert Beard
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The past year saw few significant tax cases decided in the United States Court of Appeals for the Eleventh Circuit.1 However, the court did issue two interesting opinions: one dealing with the characterization of a real estate developer's gain as ordinary income and another dealing with a statutory interpretation question relating to the first-time homebuyer tax credit. These two cases, both reversals of the United States Tax Court, are discussed below.
In Long v. Commissioner,2 the taxpayer was an individual who owned 100% of the stock of Las Olas Tower Co., Inc. (LOT). LOT's primary business activity was designing and developing a luxury, high-rise, residential condominium building known as the Las Olas Tower. The taxpayer consistently disregarded the existence of LOT by failing to file tax returns for LOT and reporting all of its income on his personal return.3 The Internal Revenue Service (IRS) apparently acquiesced in this treatment.4
The land on which the Las Olas Tower was to be constructed was owned by the Las Olas Riverside Hotel (Hotel). In 2002, LOT and the Hotel entered into an agreement (Purchase Agreement) for LOT to purchase the land for a price of approximately $8.3 million with a
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closing date of December 31, 2014. After entering into the Purchase Agreement, LOT began to develop the condominium project, including developing construction plans, getting zoning approvals, and marketing units to purchasers.5
Subsequently, the Hotel, which was under new ownership, terminated the Purchase Agreement. LOT promptly commenced litigation (Property Litigation) to enforce the Purchase Agreement.6 In November 2005, LOT obtained a judgment requiring the Hotel to consummate the sale "within 326 days from the date of entry of the final judgment."7 The Hotel was also required to pay monetary damages in an unspecified amount.8 The Hotel appealed the judgment.9
During the pendency of the appeal, LOT entered into an agreement to sell its position in the Property Litigation to Louis P. Ferris, Jr. Ferris agreed to pay $5.75 million for the taxpayer's position as the plaintiff in the Property Litigation. This sale was consummated in September 2006. Ferris dismissed the lawsuit shortly after acquiring it.10
The taxpayer was obligated to make payments of approximately $3.96 million to a lender and his ex-wife. He reported the remaining amount received from the sale as ordinary income, but improperly omitted and claimed a deduction for cost of goods sold of approximately $2.4 million. The IRS asserted that the entire $5.75 million should have been reported as gross receipts. The IRS also adjusted the claimed cost of goods sold. In the tax court, the taxpayer asserted, among other claims, that the character of his gain recognized should be capital and not ordinary.11
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Long-term capital gains received by non-corporate taxpayers are subject to preferential tax rates. The Internal Revenue Code (I.R.C.) § 1222(3)12 defines "long-term capital gain" as "gain from the sale or exchange of a capital asset held for more than 1 year."13 Section 122114 defines the term "capital asset" as any property other than certain excluded types of assets.15 Section 1221(a)(1) provides that inventory and other "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business" (dealer property) are not capital assets.16 Gain from the sale of dealer property is ordinary income.17
Depreciable, non-inventory property used in a trade or business is also excluded from the definition of capital assets, but § 123118 treats gain from the sale of such property, under certain conditions, as long-term capital gain unless the taxpayer has a net loss on such property for the taxable year.19
Finally, gain from the sale of certain property that would otherwise be classified as a capital asset can be treated as ordinary income if the property represents a right to receive future ordinary income.20 The "substitute for ordinary income doctrine" was espoused in two United States Supreme Court cases where taxpayers sold contractual rights to receive ordinary income payments (in one case, payments under an above-market lease, and in the other case, mineral royalty payments) and claimed capital gain treatment.21 A recent Eleventh Circuit decision held that the substitute for ordinary income doctrine applies where a payment is "essentially a substitute for what would otherwise be received at a future time as ordinary income."22
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The scope of the definition of dealer property set forth in § 1221(a)(1) has been the subject of exhaustive litigation and commentary.23 One context where issues frequently come up is real estate development.24 Developers who purchase tracts of land and subdivide it into individual lots are often treated as dealers, as are condominium developers who construct a condominium and sell units to residents.25
Ultimately, the question of whether property is dealer property is a factual question that depends on a variety of factors.26 One commonly cited list of factors identifies the following seven relevant criteria:
(1) the nature and purpose of the acquisition of the property and the duration of the ownership; (2) the extent and nature of the taxpayer's efforts to sell the property; (3) the number, extent, continuity and substantiality of the sales; (4) the extent of subdividing, developing, and advertising to increase sales; (5) the use of a business office for the sale of the property; (6) the character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and (7) the time and effort the taxpayer habitually devoted to the sales.27
The facts of Long called for this dealer analysis to be applied in an unusual context.28 Long recognized gain by selling an interest in ongoing litigation, as opposed to real property.29 Section 1221(a)(1) speaks of "property held . . . primarily for sale to customers."30 In this case, should the "property" described in § 1221(a)(1) be the interest in the litigation or the underlying property?
The tax court's opinion glosses over this issue, concluding with no analysis that the character of the taxpayer's gain "depends upon whether [the taxpayer] intended to acquire the Las Olas Boulevard property for investment."31 Thus, the court seems to have assumed that the § 1221(a)(1) test should be applied with respect to the underlying property.32 The parties appear to have accepted this formulation in the
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tax court proceedings, though they disagreed about what property the taxpayer ultimately hoped to acquire.33
The IRS took the position that the relevant property, which the taxpayer was attempting to acquire, was the completed condominium units in the fully constructed Las Olas Tower project. The taxpayer, on the other hand, claimed that he intended to sell the land immediately prior to commencing construction to another developer. For this reason, the taxpayer claimed that the undeveloped land should be the relevant property in the analysis.34
The tax court accepted the taxpayer's argument and concluded that the relevant question was whether the land itself would have been held as a dealer asset if acquired by the taxpayer.35 The court concluded that it would have been dealer property.36 Several factors supported this conclusion.37
According to the taxpayer's own testimony, his intention was to resell the land after performing the preconstruction development work. The taxpayer was engaged full-time in development work for the Las Olas Tower project before the commencement of the Property Litigation. The taxpayer arranged a number of presales of condominium units, and, even after he decided to sell the land prior to beginning construction, the facts indicated that he expected to make a profit primarily from his development efforts. The taxpayer, a full-time real estate developer, substantially improved the property and engaged in significant marketing efforts.38
Based on these factors, the tax court agreed with the IRS and held that the land would have been dealer property if it was acquired.39 Therefore, gain from the sale of the interest in the Property Litigation was held to be ordinary income.40
The taxpayer appealed, and the Eleventh Circuit ultimately reversed the tax court on the capital gains issue.41 At the tax court level, the IRS argued that the character of the taxpayer's gain should be determined by the taxpayer's purpose for holding the condominium units that he intended to construct eventually. The taxpayer argued, and the tax court agreed, that the character of the gain should be determined based
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on the holding purposes for the unimproved land that the taxpayer hoped to acquire.42
The Eleventh Circuit took a third view—that the relevant property was the taxpayer's right, pursuant to the court's judgment, to purchase the land for the Hotel in accordance with the terms of the Purchase Agreement.43 Under this view, the only question was whether "Long entered into the [Purchase Agreement] with the intent to assign his contractual rights in the ordinary course of business."44 Clearly this was not the case. Thus, the Eleventh Circuit concluded that the taxpayer...
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