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Tax Court: Gain from Sale of Land Held for Development was Ordinary Income.

(Parker Tax Publishing June 11, 2015)

The Tax Court determined that taxpayers' extensive and ongoing efforts to develop a parcel of property demonstrated that their primary purpose was to sell the property in the ordinary course of business, and held that they were required to report their gain as ordinary income. Fargo v. Comm'r, T.C. Memo. 2015-96.


Victor Fargo and his wife, Victoria King have been engaged in the California real estate business since the 1980s. King is a licensed real estate broker and the couple conducted their business through a number of entities, including Fargo Industries Corp. (Fargo Corp), a C corporation wholly owned by Fargo, and Girard Development, L.P. (Girard LP), a partnership of which Fargo and King were the majority partners.

In 1988, Fargo Corp acquired a leasehold from La Jolla Country Club, and planned to develop a 72-unit apartment complex and retail space on the property. The company also acquired the improvements that had been developed on the land, including a tenant-occupied building leased by a medical company, along with plans, drawings, reports, surveys, and a permit. Fargo Corp, Girard LP and other entities owned by Fargo and King used part of the building as office space.

In 1991 Fargo Corp transferred the leasehold in the property to Girard LP for a capital contribution credit. Due to a dramatic decline in the La Jolla real estate market in the 90's, development of the property was suspended. Despite the decline, in 1997 the partnership purchased the property from La Jolla Country Club for $1,750,000 as part of an attempt to obtain financing to continue development, and through 2001 the property was developed for residential use. However, the extent of physical improvements to the property was limited to minor repairs.

The only effort to sell the property was made in 1993, when Girard LP entered into a marketing and brokerage agreement with a real estate company owned by King. Even then, no substantial efforts were made to solicit potential buyers.

In 2001, Centex Homes made an unsolicited offer to purchase the property from Girard LP for $14,500,000, plus a share of the home sales profits, and the sale was completed in 2002. Centex Homes agreed to develop residential townhouses largely on the basis of Fargo's previous plans.

On its 2002 tax return, Girard LP reported a capital gain of $628,222 from the sale of the property. After auditing the return, the IRS issued a notice of final partnership administrative adjustment (FPAA), determining that the partnership had realized ordinary income from the sale in the amount of $7,474,645.


Code Sec. 1221(a)(1) defines a capital asset as property held by the taxpayer, but does not include property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.

The Tax Court has identified several factors for evaluating whether a taxpayer held certain properties primarily for sale to customers in the ordinary course of business, including:

(1) the purpose for which the property was initially acquired;

(2) the purpose for which the property was subsequently held;

(3) the extent to which improvements, if any, were made to the property by the taxpayer;

(4) the frequency, number, and continuity of sales;

(5) the extent and nature of the transactions involved;

(6) the ordinary business of the taxpayer;

(7) the extent of advertising, promotion, or other active efforts used in soliciting buyers for the sale of the property;

(8) the listing of property with brokers; and

(9) the purpose for which the property was held at the time of sale (Maddux Constr. Co. v. Comm'r, 54 T.C. 1278 (1970)).

The Tax Court held that the factors, when viewed together, weighed in favor of finding that, at the time of the sale, the La Jolla property was sold in the ordinary course of business under Code Sec. 1221(a)(1).

The court determined that Fargo Corp's original intent when it acquired the leasehold was to develop the property for resale to customers, and found Girard LP's subsequent purchase further supported that intent. Additionally, the court noted that the partnership never abandoned its development plans, even with the downturn in the La Jolla real estate market, and incurred substantial fees related to development expenses by the time the property was sold. The court found these first two factors favored the IRS's position.

The court found that factors (3), (4), (7), and (8) weighed in favor of Girard LP: the partnership never substantially improved the property; the La Jolla property was its first sale; it did not actively advertise or promote the property for sale outside of a contract with King's real estate office, and, even then, the broker made minimal efforts to contact buyers or market the property. The court did not address the sixth factor.

The court concluded that the fifth and ninth factors strongly favored the IRS. The property was sold to an unrelated entity which agreed to continue to develop the property and share profit with Girard LP, which the court noted was important to the decision to sell the property. The court pointed out the taxpayer's purpose at the time of sale was the most relevant factor, and noted Girard LP had been continuously increasing its development efforts leading up to the sale. The court believed the increased development demonstrated an intent to sell the property to customers rather than to hold it as an investment.

After weighing the factors, the Tax Court held that Girard LP sold the property in the ordinary course of its business under Code Sec. 1221(a)(1), and sustained the IRS's determination that the partnership had realized ordinary income, rather than capital gain on the 2002 sale.

For a discussion of capital assets, see Parker Tax ¶ 111,105. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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