Capital Gain on Development Property

In Timothy J. Phelan, TC Memo 2004-206, the taxpayers segregated their real estate operations to achieve capital gain treatment on property ultimately held for development. Three entities were formed with identical ownership to engage in various aspects of the real estate business:

• Centre Development Co. of Colorado Springs, LLC (Centre) owned a shopping center.

• Jackson Creek Land Co. (JCLC), a limited liability company, invested in undeveloped property.

• Vision Development Corp. (Vision) developed and sold JCLCs property.

Facts

In 1994, JCLC acquired 1,050 acres of Regency Park (called Jackson Creek), a property located in an independent Colorado subdivision known as Triview (an independent quasi-governmental municipal corporation and political subdivision). In 1987, Triview agreed to construct water and sewer improvements and contracted with the town of Monument, CO, to construct roads and sanitation and other facilities. Monument annexed Regency Park and rezoned the property for residential and commercial development.

During 1996, JCLC authorized a geological study to evaluate development potential. In 1997, Elite Properties of America Corp. (Elite) negotiated with JCLC to acquire 102 acres, requiring the latter to cause Triview to maintain irrigation and landscaping and be responsible for any utility or roadway improvements that Monument imposed. Triview completed all development work.

In 1996, Triview defaulted on general obligation bonds it had issued in 1987. Centre paid $2.9 million for $4.8 million of the defaulted bonds; two utility companies purchased new Triview bonds for $1.5 million. Collateral for Centres financing included the 1987 Triview bonds and Jackson Creek.

In 1997, Vision and JCLC borrowed $600,000 to finance infrastructure development on 184 acres. The loan was guaranteed by the taxpayer, Centre and a related construction entity.

Tax Courts Opinion

The issue was whether JCLC held Jackson Creek for sale in the ordinary course of its business. The court addressed the following questions:

• Was JCLC engaged in a trade or business, and if so, what business?

• Was JCLC holding the property primarily for sale in that business?

• Were the sales contemplated by JCLC ordinary in the course of that business?

The court observed that although JCLC was aware of Triviews development obligations, JCLC was organized with the intent to hold the Jackson Creek property for investment and appreciation in value, a significant factor. While the members of JCLC engaged in substantial real estate activities through various entities, they individually did not hold real estate licenses, and JCLC did not advertise the property for sale, nor hire representatives to do so.

The Service argued that Triviews improvements occurred under the direction of JCLC and related entities. The court noted that while JCLC was responsible for limited improvements to the land sold to Elite, it did not have employees or engage in any business activities outside of holding and selling a limited number of parcels. The court acknowledged that while bond proceeds assisted Triview, none of the bond investors controlled Triview, nor was the cash infusion used for JCLCs direct benefit.

The Service attributed Visions development activities to JCLC based on a tax avoidance routine. Stating that incorporating Vision to perform the development work protected JCLCs sole asset, the court found that because Vision had been organized for a legitimate business purpose and all corporate formalities were followed, its development activities were not attributable to JCLC.

The Service argued that substantially all of JCLCs 1998 income was derived from gains on real property sales. Unpersuaded, the court opined that although JCLC held the property for four years prior to sale, it did not engage in any other economically beneficial activity and two property sales in four years did not constitute a business.

From Bud Sartain, CPA/ABV, Tullius Taylor Sartain & Sartain LLP, Tulsa, OK