Recent rulings in real estate development.

• Author: Elliott, Eric R.

With the slowdown in the real estate market continuing, many taxpayers with investments in undeveloped real estate are attempting to find creative ways to realize the built-in profit on their existing holdings. This planning may involve a real estate developer's attempting to sell a large tract of land originally scheduled for development or a real estate investor's subdividing and developing property originally intended as a long-term investment. Based on this recent trend in the marketplace, practitioners should review with clients the attributes of a developer versus an investor of real estate holdings.

Background

Sec. 1221(a)(1) defines a capital asset as property held by a taxpayer (whether or not connected with the taxpayer's trade or business) that is not primarily for sale to customers in the ordinary course of his or her trade or business. If an asset does not meet this definition, it will potentially be subject to tax at more than double the current capital gain tax rates.

Several cases have attempted to clarify the "primarily held for sale" definition. In Fraley, TC Memo 1993-304, the Tax Court reaffirmed eight factors that should be considered when making the "purely factual determination" of whether or not land is primarily held for sale to customers in the ordinary course of a trade or business:

1. The purpose for which the property was acquired;

2. The purpose for which the property was held;

3. The extent of improvements made to the property;

4. The frequency of sales;

5. The nature and substantiality of the transactions;

6. The nature and extent of the taxpayer's dealings in similar property;

7. The extent of advertising to promote sales; and

8. Whether the property was listed for sale, either directly or through brokers.

Note that the courts have concluded that the existence of any one factor or group of factors does not characterize property as primarily held for sale to customers. Instead, each situation must be considered based on its own facts and circumstances.

Recent Developments

Many real estate investors wonder whether they will jeopardize their investor status if they begin to promote, subdivide, or otherwise begin to take on certain traits of a developer. In Phelan, TC Memo 2004-206 (the most recent case on this issue), the taxpayer was involved in limited activities that might be deemed to be inconsistent with capital-asset status. The taxpayer was contractually obligated, at its sole expense, to make limited...