I wrote this quite a few years ago, but a recent case Boree v Com TC Memo 2014-85 has brought the issue of dealer versus investor to the fore. There will be piece on Boree on my forbes blog passive activities soon and this provides a supplement. If you want capital gains treatment for a land sale, Boree is more or less a what not to do case. Phelan, on the other hand shows how to make it happen.
I remember a time long ago when among young people, myself being one of them, when there would be discussion on “how far” one could go and still technically remain a virgin. Imagining the various gradations could be quite stimulating. Contemplating Phelan v. Commissioner, TC Memo 204-206 might bring similar feelings to those, myself among them, who struggle with the question of when an investor in real estate is no longer an investor. Why is the question important?
The most obvious reason and the one that was the concern in the Phelan case is the favorable rate for capital gains. The investor gets the favorable rate and loses it if he crosses over into being a developer or dealer. Even more significant the investor can avoid gain recognition by structuring the sale of one property and the purchase of another as a like-kind exchange under Code section 1031. If there are losses, it might be more favorable to be a developer or dealer, who will get ordinary loss treatment. Even in this area, the investor can come out better in some circumstances. Deductions may be allowed that would otherwise be suspended under the passive activity loss rules. In general, however, dealer developer status will be more favorable in loss situations. Nobody goes in expecting to lose, though, so planning will be to gain favorable treatment for sale.
If you buy land and don’t do anything but pay taxes and liability insurance, when a prospective buyer happens to notice the land (without any help from you), the resulting sale will be a capital gain. If, on the other hand, your sole source of livelihood is buying land, improving it and subdividing in order to sell as quickly as possible, the resulting sales will be ordinary income. There is a lot of room between the two extremes. The IRS and the taxpayer often differ as to whether the imaginary line has been crossed. Such was the Phelan case.
The Phelan brothers were involved in both real estate development and construction. Along with their partner they formed a single purpose entity (Jackson Creek Land Corporation-JCLC) to own the particular tract of land in question (which they designated Jackson Creek). JCLC was considered a partnership for income tax purposes. The court found the formation and operation of this single purpose entity very significant. It also noted that the Phelan’s real estate business conducted thorough other entities concerned commercial real estate rather than residential real estate projects, such as Jackson Creek.
The transactions involved in the Jackson Creek project were rather complex. The property was part of a larger tract that had been acquired by a developer (the Regency Group) in the 1980’s. In 1987 the developer entered into an agreement with Triview. Triview was a political subdivision of the state of Colorado, with the authority to levy taxes, issue bonds and assess fees. Regency, Triview and the adjacent town of Monument entered into an agreement obligating each of them to make infrastructure improvements and in the case of Regency pay fees. Monument annexed the land of the project to become part of the town, but the various agreements stayed in force. Shortly, thereafter Regency filed for bankruptcy.
Phelan acquired the property from J&L Higby trust which had acquired it form Regency. Shortly after acquiring the property in 1994, Phelan deeded the land to JCLC. The transfers were all subject to the various infrastructure agreements.
JCLC performed a Preliminary Geological Investigation on the land and finalized a development plan with Monument that allowed for the commencement of construction.
JCLC first capital gain transaction was in 1998 when it agreed to sell 102 acres (a bit les than 10% of the acreage) to Elite properties in three separate closings. JCLC agreed to cause Triview to make certain improvements and to make others itself. All the work ended up being done by Triview, including the portion that JCLC was supposed to do itself.
The next capital gain transaction was with Vision Development Corporation, an entity owned by the same people who owned JCLC in the same proportion. Vision was formed to do development work on 46.5 acres in order to prepare it for sale to a home builder. The plot now thickens. Triview it develops is in default on its bonds. Through a series of transactions involving other entities controlled by the Phelans, the bonds were refinanced and additional bonds were purchased. Presumably this is what allowed Triview to complete the infrastructure improvements it was obligated to perform...There was, however, no direct link between the two events.
Finally Vision and JCLC entered into a revolving loan agreement which would allow Vision to make improvements on a 184 acre parcel for sale to homebuilders.
The attached time line might help to clarify the transaction history.
Looking at it through the jaundiced eye of a revenue agent, it would appear that three people got together, bought some land cut it into pieces and directly or indirectly made substantial improvements. The court, however, ruled that the sales by JCLC produced capital gains.
The factors that the court considered in arriving at its opinion
- JCLC was formed with the investors knowing that the various pieces to allow its ultimate development were basically in place and expected the property to appreciate.
- The offer from Elite was unsolicited
- None of the owners of JCLC held broker’s licenses
- JCLC did not advertise or hire representatives.
- Although JCLC promised Elite that Triview would do certain things, this only gave Elite recourse against JCLC.
- JCLC had no employees. Although it was obligated to make improvements if Triview did not.
- The risks and rewards associated with the purchase of bonds by related parties were not directly tied to the Jackson Creek project.
- With respect to the sale to Vision, even though JCLC owners were not personally liable, they protected their interest in the balance of the land by carving off the portion going to Vision. This was a valid non-tax motivation for the transaction.
- The four year holding period and limited number of sales.
The court did not consider the geological survey, gaining approval for the final development plan and the limited subdivision sufficient to create a trade or business.
In considering the implications of this decision, there are two things to keep in mind. One is that the tax court emphasized that it was using principles from the tenth circuit. The other is that the involvement of the various entities with a quasi-governmental is an unusual circumstance. Nonetheless, it appears that you can go pretty far and still remain an investor.
It can be pretty challenging to follow the decision. You might find this timeline helpful or not.
It can be pretty challenging to follow the decision. You might find this timeline helpful or not.
July 27,1993- Centre Development Corporation formed to purchase a shopping center. Owned by Phelan, his brother and third party name Oldach,40/40/20.
1994 – Real estate agent inform Phelan of 1050 acres in Regency Park soon to be listed
1994 – Phelan, his brother and one other person Oldach) form Jackson Creek Land Company (a Colorado Limited Liability Corporation). Phelan and his brother each own 40%, Oldach owns 20%. Sole JCLC was to acquire Regency Park. None of the three owners held real estate licenses.
October 31, 1994 – Phelan buys 1050 acres for 2.9 Million Sale was subject to several infrastructure agreements with governmental agencies. (Triview Metropolitan District
December 7, 1994 – Phelan quitclaims property to JCLC for 2.9 million. Property is renamed Jackson Creek.
1996 (???)- Elite express no interest in developing 46.5 acres for sale to Keller Homes.
1996- Phelan brothers and Oldach form Vision Development Corp. Same 40/40/20 split
1996 – Preliminary Geological Survey
1996- Triview in default on bond 4.8 Million principal and 3.0 million interest.(bonds issued in 1987)
1996- Center Development (owned by JCLC owners) purchase defaulted bonds from Mass Development and Kemper. Uses margin loan and 1.5 Million borrowed from utility companies
1997 – Elite properties approaches JCLC to acquire part of the property
August 18, 1997 – P&S between JCLC and Elite properties
September 22, 1997 -, Centre and JCLC borrowed the 1.5 Millon from Colorado National Bank (CNB) to refinance loan from utilities. Guaranteed personally, by brothers and Colorado Structures (see below 1998) and mortgage of JCLC property, JCLC named as a borrower but receives none of the proceeds.
1998 – Utility companies purchase 1.5 million of new Triview bonds
1998- Colorado Structures purchases new Triview bonds from utilities
August 18, 1997 – P&S with Elite
January 5, 1998 – JCLC sells 46.5 acres to VDC for 1.6 million Partnership return reflects LTCG of 50k. Purpose of VDC was to develop 46.5 acres for sale to Keller Homes.
1998- Colorado Structures, which is owned 49% by Phelan brothers 51% by ESOP does 117Million of construction business. None of it is residential
March 19, 1998 – Revised P&S. Elite to purchase 102 acres in three separate closings. JCLC required to cause Triview to make some infrastructure improvements and JCLC to do others at its own expense. (Ultimately they were all done by Triview)
June 15th 1998 – First closing $792,880 – reported on partnership return as LTCG
1999- Colorado Structures purchases new Triview bonds
1999 – Second closing with Elite
2000- Third closing with Elite