In Boree v. Commissioner, 118 AFTR 2d 2016-5742 (11th Cir., Sep. 12, 2016), the Eleventh Circuit held that the county's adoption of subdivision regulatory requirements after taxpayers had purchased certain real property was insufficient to show that the taxpayers had changed their intent in holding the underlying property from development to investment; accordingly, the taxpayers' gain from the sale of the underlying property constituted ordinary income.
The taxpayers in Boree acquired vacant real property in November 2002 (the "Property"). Shortly thereafter, the taxpayers sold one small parcel of land. The taxpayers then submitted plans to the county to rezone the Property for residential development. The county approved the plans proposed by the taxpayers and rezoned the Property to allow 10-acre lots. After the rezoning in 2003, the taxpayers sold an additional 15 lots. From 2003 to 2004, the taxpayers created a homeowners' association for the Property and held themselves out as the developers of the Property, both in writing and in actions taken by the taxpayers such as obtaining the county's approval for the Property development plan, applying for permits, establishing easements for utilities, and constructing an unpaved road.
In 2005, the county adopted a new requirement that all subdivision roads be paved. At this time, the Property had a number of unpaved roads. Accordingly, the taxpayers requested an exception from the county's new requirement, due to the high cost of compliance for the taxpayers. The county denied this request. The taxpayer submitted another rezoning request to the county for a planned unit development that would increase the density at the Property to offset the costs of paving the roads. Although the county recommended approval of this plan, the taxpayers withdrew the proposal and instead sold all of the Property to another developer that owned an adjacent tract of land.
The taxpayers reported gain from the sale to the developer as long-term capital gain, although the taxpayers had reported ordinary losses from various other lot sales occurring between the time of acquisition and the developer sale in 2007. The taxpayers argued that their purpose and intent in holding the Property changed when the county adopted the new paved roads requirement.
Generally, any property held by the taxpayer is a capital asset unless the property satisfies one of the statutory exceptions. However, a sale of "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business" produces ordinary income rather than capital gain. I.R.C. § 1221(a)(1). Courts also review the following factors to determine whether the property was held for sale in the ordinary course of business: (1) the nature and purpose for acquiring the property and the duration of the taxpayer's ownership of the property; (2) the taxpayer's efforts to sell the property; (3) the frequency, number and continuous nature of any sales (including the taxpayer's profit from any sales); (4) the taxpayer's actions in subdividing, developing and advertising the property in an effort to increase sales (including any improvements made by the taxpayer to prepare the property for sale); (5) whether the taxpayer used a business office for selling the property; (6) the taxpayer's level of supervising or control over any third-party agent used to sell the property; and (7) the taxpayer's time and effort devoted to selling the property. In similar cases, courts also have reviewed the taxpayer's income from the sale or sales as compared to the taxpayer's total income for the period, how the taxpayer reported the transactions on his or her tax returns and whether the taxpayer subsequently acquired adjacent land.
The Eleventh Circuit upheld the Tax Court's determination that the taxpayers held the Property primarily for sale in the ordinary course of business. The court first acknowledged that the taxpayers initially acquired the Property for sale in the ordinary course of business. Although the taxpayers contended that their intent changed due to the subdivision requirements, the court rejected this argument. First, the court noted that the subdivision requirements did not deprive the taxpayer of all potential income-producing uses of the Property; the requirements simply increased the costs of certain types of development activities. Second, and more importantly, even after the county adopted the subdivision requirements, the taxpayers continued to take actions designed to position the Property for subdivision and sale in the ordinary course of business, specifically by (A) seeking exceptions from the county; and (B) applying to rezone the Property for higher-density residential development.
The Boree case is of particular importance to real estate practitioners because few cases consider the implications of post-acquisition land use restrictions on the character of a taxpayer's gain from a subsequent sale of the property. As Boree shows, the existence of subdivision regulatory requirements adopted after the taxpayer acquired the property is insufficient to show that the taxpayer's intent in holding the property changed to that of an investor. In such a case, all of the facts must be reviewed to determine whether the taxpayer's intent actually changed, including the taxpayer's actions subsequent to the imposition of the subdivision requirements.
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