Securing capital gains on development property.

• Author: Dodge, Justin

Real estate developers are constantly striving for ways to treat income from developed property as capital gain. As discussed in this item, case law exists to supports capital gain treatment on a portion of the income from these transactions, if structured properly.

Bramblett

In Bramblett, 960 F2d 526 (5th Cir. 1992), rev'g TC Memo 1990-296, several investors set up Mesquite East (ME), a partnership, to purchase raw land. The partnership's stated purpose was real estate investment. ME held the purchased land for several years before the partners decided to develop and sell it. They sought to maximize capital gain treatment.

To achieve this goal, the taxpayers created a corporation, Town East (TE), to develop and sell real property. TE's ownership was the same as ME's. ME sold parts of the raw land to TE in three separate sales. Before these sales were made, TE had already entered into an agreement to develop the land, then sell it to an outside party. ME made a fourth sale directly to a different party. The total consideration for the four sales was $1,645,685.

Subsequent to the above activity, potential purchasers began contacting ME about purchasing portions of the remaining property, which represented the bulk of the original investment. The taxpayers had intended to sell the remaining raw land in a single purchase, so as not to risk losing capital gain treatment.

ME obtained an independent appraisal of the remaining property. Based on this, it sold the remaining property to TE for $9.83 million, by giving TE two notes payable and treating the transaction as an installment sale.

At no time during the years in issue did ME hire brokers or attempt to advertise or sell any part of its property. ME did not maintain an office; none of its partners spent more than a minimal amount of time on its activities. ME did not subdivide, develop or improve any of its property.

ME considered the raw land a capital asset at the time of its sale to TE and, thus, reported the sale proceeds as capital gain, which the IRS contested.

Tax Court

The Tax Court agreed with the Service, for several reasons. The most critical reason was that it believed that ME's trade or business was the sale of land, whether conducted directly or indirectly through TE. Thus, it held the sale gain to be ordinary. The taxpayer appealed.

Fifth Circuit

The appellate court reversed the Tax Court's decision, determining that TE's activities could not be attributed to ME. In Brown, 448...