Property Held For Resale: What One Bad Apple Can Do

By: Amy K. Walsh, CES®
Submitted: 02:56PM on Friday 24 April 2009

One issue that seems to plague developers and other real estate investors is the practice of lumping their investment and income-producing properties in with properties held for development and resale. Of particular value in gauging the consequences of this is the case of Neal T. Baker Enterprises, Inc. v. Commissioner (TC Memo 1998-302), in which the significance of carefully separating property intended to held as investment as far as possible from property to be held for sale, “flipping” or development is highlighted. There are numerous reasons this is crucial, but the main points are three-fold; accounting-wise, entity-wise and marketing-wise.

The taxpayer’s company in Baker was a developer of residential subdivision properties, while dabbling in unimproved land and investment properties on the side. In 1978, the taxpayer bought a raw tract that had been zoned for single family residential. Ten years later, fourteen subdivision lots had been developed and homes constructed on them. They were then sold and reported as ordinary income in the course of business. The expenditures for subdivision infrastructure and improvements were shown on the company’s books as “works-in-progress” or “construction-in-progress,” consistent with developer inventory treatment. Some of the other tracts were recorded as “undeveloped or vacant land” accounts that would be consistent with investment treatment; however, both sets of properties were still held in the same entity, which can be confusing and extra work for the accountant, at best.

During this year the taxpayer received an offer to purchase the remainder of the tract. The taxpayer submitted the transaction as a tax-deferred exchange, and come tax return time he drew the audit card. The IRS denied the exchange, stating the property was held primarily for resale and not for investment, and thus was non-qualifying. The taxpayer argued that his intention changed with respect to the property from the original development plan to a qualifying investment plan. However, actions speak louder than words, and none of his said the right thing. He never separated the property from the development entity, he never reclassified it from “work-in-progress” to an investment-friendly intent on his books or returns, nor did he hold it away from the advertisements for the development of the property. The taxpayer then attempted to argue that another recent case, Paullus v. Commissioner, should apply to him as well because it had similar circumstances, and deferred treatment was granted to Paullus. Unfortunately, the Tax Court pointed out that in the Paullus case, a separate operating entity from the development entity owned the investment property and conducted the exchange, which Baker had never bothered to do.

In addition to the separate entity and accounting classifications, other cases bring home the point that all marketing and advertising activities need to be excluded on the investment properties as well. For example, in Graves v. Commissioner, the taxpayer divided the property into four parcels, developed three of them and left the fourth parcel raw and attempted an exchange. The Tax Court held that the fourth parcel was non-qualifying because it was always included with the other three; their smoking gun was the advertising sales and literature which clearly showed anticipated development on all the property as part of the project. On the opposite side is Fabiani v. Commissioner, where residential developers acquired a large acreage tract and planned to use 19.3 acres for an industrial development which would subsequently be held for business operation. The Tax Court agreed with this exchange, saying that the acreage qualified for investment, since it had been sufficiently separated from all other developer/dealer activity in their residential development business.

So, what does this mean for taxpayers who operate in the development or dealer capacity? Can they not own investment properties at all? Are they going to be targeted for exchange disqualification just because their businesses are considered to be on the Dark Side of the Force? Absolutely not. What it does mean is that they should take preliminary steps to structure the investment side of their real estate correctly so as not to incur the wrath of the Service. Always form an entity that exists solely to hold and operate the investment properties and their management. Do not commingle income or funds from the investments with other development company accounts. Remove any questionable marketing attached to the properties and bifurcate any sections of properties into the separate entity that are part of a whole to be developed. Make certain that the accountant is classifying these properties as investment, not as “works-in-progress” or development. When purchasing properties for the investment entity, be sure they will be held for a recommended amount of time to prove investment intent; fixing properties up and putting them back on the market or listing them within a short period of time after purchase will classify them as dealer property - held for resale, and disqualify them for an exchange. Above all, work closely with all tax advisors to ensure the proper actions are taken from the beginning to keep from getting a rude awakening at tax time.