T.C. Memo. 2011-137
UNITED STATES TAX COURT
MARK S. AND CHERYL R. GARDNER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15676-09. Filed June 20, 2011.
Gregory P. White, for petitioners.
Molly H. Donohue and Mary P. Hamilton, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HALPERN, Judge: Respondent determined a $39,059 deficiency
in, and a $9,764.75 addition to tax with respect to, petitioners’
2004 Federal income tax.
The parties have resolved several of the adjustments giving
rise to that deficiency, and some are only computational. They
have left two issues for us to decide: (1) The character of gain
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realized on petitioner husband’s disposition of a portion of one
parcel of real property and (2) his purpose in holding a second
parcel of real property. Petitioners assigned no error to
respondent’s determination of the addition to tax (for failure to
file timely their 2004 return), nor do they address it on brief,
beyond conceding that they were late in filing that return. We
assume, therefore, that they concede their liability for the
addition to tax (adjusted to take account of the deficiency we
redetermine), and we shall not further address it. See Rule
151(e)(4) and (5); Sundstrand Corp. & Subs. v. Commissioner, 96
T.C. 226, 344 (1991).
Unless otherwise stated, section references are to the
Internal Revenue Code in effect for 2004, and Rule references are
to the Tax Court Rules of Practice and Procedure.
Petitioners bear the burden of proof. See Rule 142(a).1
1
Petitioners have not raised the issue of sec. 7491(a),
which shifts the burden of proof to the Commissioner in certain
situations. We conclude that sec. 7491(a) does not apply here
because petitioners have not produced any evidence that they have
satisfied the preconditions for its application.
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FINDINGS OF FACT
Introduction
Some facts have been stipulated and are so found. The
stipulation of facts, with accompanying exhibits, is incorporated
herein by this reference.
Petitioners, husband and wife, resided in Massachusetts at
the time they filed the petition.
For 2004, they made a joint return of income on Form 1040,
U.S. Individual Income Tax Return, for that year.
Petitioner’s Real Estate Activities in General
Petitioner husband (petitioner) is self-employed. On a
Schedule C, Profit or Loss From Business, attached to their 2004
Form 1040, petitioner described his business as “carpentry/site
contracting”. Over approximately the last 26 years, petitioner
bought and sold 16 parcels of real property. Often, he would buy
unimproved land, build a single-family residence thereon, and
immediately sell the improved property. Occasionally, he bought
and sold unimproved land. Petitioner also bought unimproved land
and constructed multifamily housing thereon or bought land
improved with multifamily housing and improved the housing.
Petitioner did not immediately sell his multifamily housing
properties but kept them for rental income.
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Petitioner used brokers to assist in the sale of many of the
properties he sold. He maintains a business office outside his
home but employs no staff at the office.
Petitioner’s Purchases and Sales of Multifamily Properties
Petitioner purchased a five-family property on School Street
in Rockland, Massachusetts (Rockland), in 1983 and still owns it.
He acquired property on Myrtle Street in Rockland in 1984,
constructed a two-family rental unit thereon, and sold the
property in 1989. He purchased property improved by a two-family
rental unit on Blanchard Street in Rockland in 1986 and sold it
in 1990. He purchased rental property on Church and Howard
Streets in Rockland in 1987 and still owns it. He purchased
property improved by a five-family rental unit on Oak Street in
Middleboro, Massachusetts, in 2006 and still owns it.
East Water Street Property
In March 2004, petitioner purchased from his brother and
sister-in-law property on East Water Street in Rockland that had
been approved for subdivision into five lots. After acquiring
the property, petitioner built a road on it, which was necessary
to access the five lots. He conveyed to his brother one of the
lots, on which he constructed a house for his brother and his
family. In November 2004, petitioner sold three of the remaining
lots (the three lots) for $750,000. Petitioners reported the
gain from the sale of the three lots on Schedule D, Capital Gains
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and Losses, to their 2004 Form 1040, claiming a basis of $376,159
and showing a short-term capital gain of $373,841. Petitioner
sold the remaining lot in 2005 for $215,742. Respondent
disallowed petitioners’ treatment of the gain from the sale of
the three lots as short-term capital gain and recharacterized the
transaction as a sale of property held for sale to customers in
the ordinary course of petitioner’s trade or business, which
respondent treated as a transaction reportable on the Schedule C.
Because of the resulting increase in petitioner’s Schedule C
income, respondent increased petitioner’s net earnings from self-
employment, which gave rise to a $16,104 increase in petitioner’s
self-employment tax (and an offsetting self-employment tax
deduction of $8,052).
Petitioner testified that the three lots were “duplex lots”
(we assume lots appropriate for building duplex housing) and his
original intention was to keep those lots “to add to my investor
status but unfortunately the roadway cost me so * * * [much] I
had to sell those lots. I had no choice.”
242 Beech Street Property
In 1997, petitioner purchased a 34-acre industrial lot at
242 Beech Street in Rockland. He testified that he had purchased
the property for investment and thought that he had paid $400,000
for it. Thereafter, he obtained approval to subdivide the
property into 79 lots. In 2006, he sold the property for $4
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million. During 2004, petitioner kept heavy equipment related to
his carpentry/contracting business on the property. Petitioner
did not rent the property to anyone during the time he owned it.
On Schedule E, Supplemental Income and Loss, to their 2004
Form 1040, with respect to the property, petitioners claimed a
$99,956 deduction for: (1) Legal and other professional fees of
$62,967, (2) mortgage interest of $26,860, and (3) real estate
taxes of $10,129 (together, the Schedule E expenses), all of
which respondent disallowed on the ground that the Schedule E
expenses did not relate to rental of the property. Petitioner
actually paid the $62,967 claimed to be for legal and other
professional fees for engineering services attendant to surveying
and subdividing the property.
OPINION
I. Gain From the Sale of the Three Lots
We must determine whether the character of petitioner’s gain
from the sale of the three lots was capital gain (short-term
capital gain) or gain from the sale of property held primarily
for sale to customers in the ordinary course of his business. If
the latter, the principal negative consequence to petitioner
appears to be an increase in his net earnings from self-
employment and the imposition of a self-employment tax (offset,
in part, by a self-employment tax deduction).
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In relevant part, section 1221(a)(1) excludes from the
definition of a capital asset “property held by the taxpayer
primarily for sale to customers in the ordinary course of his
trade or business”.
Respondent argues that petitioner has a 20-year history of
buying real properties, improving them, and then selling them.
Respondent would include in that description the East Water
Street property, which included the three lots. Respondent
states: “Petitioner’s purpose in acquiring and holding the East
Water Street property was to sell the subdivided lots.”
Respondent argues that a consideration of the factors that courts
have recognized as helpful guides in determining whether a
taxpayer is holding property for sale in the business of buying,
developing, and selling property indicates just that with respect
to petitioner and the three lots.
Petitioner concedes that he was a dealer in real properties
but argues that he was also an investor:
The difference being delineated in [is] the variety in
nature and extent of his various business interests.
There is little long term investment profit in the
single family rental business but the extent and
duration of the Petitioner’s holdings of multi-family
properties/inventory evidences the investment value of
the multi family rental business.
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He adds: “The ‘multis’ were investment portfolio properties held
not to be sold in the ordinary course but to generate rental
income.”
The parties agree that Mathews v. Commissioner, 315 F.2d 101
(6th Cir. 1963), affg. T.C. Memo. 1961-213, is representative of
the numerous cases distinguishing between property a taxpayer
holds for investment and property he holds primarily for sale to
customers in the ordinary course of his business. In Mathews v.
Commissioner, supra at 106, the Court of Appeals stated: “It is
true * * * that a taxpayer may hold lands primarily for sale to
customers in the ordinary course of his trade or business and, at
the same time, hold other lands for investment.” It continued:
It is well settled that the question whether
property sold by a taxpayer at a profit was property
held by the taxpayer primarily for sale to customers in
the ordinary course of his trade or business, within
the meaning of the statute, is essentially a question
of fact. * * * No single factor or test is
dispositive. Among the factors considered are: (1) the
purpose for which the property was acquired; (2) the
purpose for which it was held; (3) improvements and
their extent, made to the property by taxpayer; (4)
frequency, number and continuity of sales; (5) the
extent and substantiality of the transactions; (6) the
nature and extent of taxpayer’s business; (7) the
extent of advertising to promote sales, or the lack of
such advertising; and (8) listing of the property for
sale directly or through brokers.
Id. at 107.
Petitioner was a credible witness, and we accept his
testimony and find accordingly that he purchased the East Water
Street property for investment purposes, in part to build duplex
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rental units on the three lots. Petitioner also convinced us
that he purchased or constructed multifamily rental units not for
immediate sale to customers but, rather, as an investment, for
rental income and, we assume, appreciation. Certainly, he did
sell two of the multifamily rental units, see supra p. 4, but
only after holding them for 4 or 5 years. He has owned two other
of those units for over 20 years and the fifth for 4 years.
While petitioner did not detail for us the financial pressures
that caused him to conclude that he could not develop the three
lots as multifamily housing notwithstanding that he could sell
them at what appears to be a substantial profit, we are persuaded
that the three lots were intended for petitioner’s multifamily
rental activity and not his build-and-sell activity. We
therefore find that petitioner did not hold the three lots
primarily for sale to customers in the ordinary course of his
business. The lots were capital assets, and the resulting gain
was short-term capital gain.
II. Schedule E Expenses
Petitioner purchased 242 Beech Street in 1997. He held the
property for 9 years and then sold it for a substantial profit.
During the interval, he incurred expenses for engineering
services attendant to surveying and subdividing the property, and
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he obtained permission to subdivide it into 79 lots. He kept
heavy equipment on a portion of the property. He obtained no
rental income from it.
Petitioner argues that the property was integral to his
business and that the Schedule E expenses incurred with respect
to the property for engineering services, interest, and taxes are
deductible under section 162 as ordinary and necessary business
expenses.
Section 263A requires the capitalization of certain costs
(e.g., interest and taxes) that might otherwise be deductible.
Respondent argues that the Schedule E expenses must be
capitalized pursuant to section 263A because: (1) They are
direct or indirect costs of the property and (2) the property is
property to which that section applies; viz, real property
“produced” by petitioner.2 See sec. 263A(a)(1)(B), (2), and (b)
(1).
2
At trial, on questioning by the Court, respondent’s counsel
conceded that the Schedule E expenses consisting of interest and
taxes would be deductible whether they were properly reportable
on Schedule E or on the Schedule C. Subsequently, counsel asked
to address on brief whether they should be deductible. We
agreed. In his brief, respondent argues that the interest and
taxes are capital expenditures and not immediately deductible.
Petitioner had the opportunity in his reply brief to address
respondent’s arguments with respect to the interest and taxes,
but chose not to do so. We shall, therefore, relieve respondent
of his concession.
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For purposes of section 263A, the term “produce” includes
“construct, build, install, manufacture, develop, or improve.”
Sec. 263A(g)(1).
In pertinent part, section 1.263A-2(a)(3)(ii), Income Tax
Regs., provides:
(ii) Pre-production costs. If property is held for
future production, taxpayers must capitalize direct and
indirect costs allocable to such property (e.g.,
purchasing, storage, handling, and other costs), even
though production has not begun. If property is not
held for production, indirect costs incurred prior to
the beginning of the production period must be
allocated to the property and capitalized if, at the
time the costs are incurred, it is reasonably likely
that production will occur at some future date. Thus,
for example, * * * a real estate developer must
capitalize property taxes incurred with respect to
property if, at the time the taxes are incurred, it is
reasonably likely that the property will be
subsequently developed.
Among the indirect costs of property that must be
capitalized under section 263A are taxes, see sec. 1.263A-
1(e)(3)(ii)(L), Income Tax Regs., and engineering and design
costs, see sec. 1.263A-1(e)(3)(ii)(P), Income Tax Regs.
Also, interest paid or incurred during the production period
of real property must be capitalized under the special rules of
section 263A(f). Sec. 263A(f)(1)(A), (B)(i), (4)(A)(i); sec.
1.263A-12(a), Income Tax Regs. (in contrast to interest,
commencement of production period is not a threshold for
capitalization of other direct and indirect costs associated with
production). The term “production period” means the period
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beginning on the date on which production of the property begins
and ending on the date on which the property is ready to be
placed in service or is ready to be held for sale. Sec.
263A(f)(4)(B). The production period for real property begins
when any physical production activity begins. See sec. 1.263A-
12(c)(2), (e), (f), Income Tax Regs. Planning and design
activities, however, are not considered physical production
activities. Sec. 1.263A-12(f)(1), Income Tax Regs.
Petitioner testified that he purchased the property for
investment, but he did not further describe his investment
objectives. We take from the fact that he did not rent the
property but prepared it for subdivision that his investment
objective was to subdivide the property and sell it. While he
did keep heavy equipment on the property, we are unconvinced that
such use was other than incidental to his objective of developing
the property by subdividing it and then reselling it. We
conclude that, during 2004, petitioner held the property for
production within the meaning of section 263A and the regulations
thereunder. See sec. 263A(g)(1) (including as production
development and improvement). We further conclude, however,
that, during 2004, no physical production activity on the
property had commenced. Petitioner’s planning and design
activities did not constitute physical production. See sec.
1.263A-12(f)(1), Income Tax Regs. Nor, without more, do we
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consider the storage of vehicles on the property a physical
production activity.
Therefore, the Schedule E expenses of $62,967 and $10,129
for engineering services and real estate taxes, respectively,
must be capitalized; the mortgage interest expense of $26,860 is
not capitalized.
Decision will be entered
under Rule 155.