By Andrew Potter
The Law Offices of Andrew G. Potter

This is a Tax Court case for the tax year 1989, which examines the exclusion from eligibility under IRC §1031 of "property held primarily for sale." Another recent case, Loren F. Paullus v. Commissioner, TC Memo 96-419 (see Federation of Exchange Accommodators Update Newsletter - 3/97), dealt with the same issue, but with a different result.

In this case, the Taxpayer was a California corporation, incorporated in 1957, to operate drive in restaurants and to construct and sell buildings. The Taxpayer was one of the original fast-food operators in the United States. In 1969, the Taxpayer underwent a reorganization and spun-off its restaurant operations into a second corporation, Baker's Burger, Inc. ("Burgers"). The Taxpayer retained the contracting business. After 1969, the Taxpayer constructed fast-food locations and leased them to Burgers, constructed residential properties, and held unimproved land. The Taxpayer held a California contractor's license but did not have any construction equipment. Construction was always contracted through third party subcontractors. Prior to the completion of a construction project, the Taxpayer's books reflected expenditures in "work-in-progress" or "construction-in-progress" accounts. The Taxpayer used third party realtors to sell real properties.

The Taxpayer purchased the R-1 zoned Beaumont property in 1978 contingent upon City's approval of a Tentative Subdivision Map for single-family residences. A 48 lot tentative map was approved and in 1979. The Taxpayer filed an application with the California Department of Real Estate for a Public Report in connection with this subdivision. Another engineer was hired and a revised tentative map with 56 lots was approved in July, 1980. The Taxpayer decided to develop the Beaumont property in phases and subcontracted for the construction of off-site improvements for 14 lots ("Tract 1001 8-l") in 1981. In December 1983, the final map for Tract 100 18-01 was recorded. Sewer connections were installed on Tract 100 18-1 in 1984 and, finally, in late 1986, the Taxpayer entered into contracts with subcontractors for the construction of houses on Tract 100 18-1. The construction of 6 houses began in October, 1986, and the other 8 houses in June, 1987. The 14 houses in Tract 100 18-1 were sold to separate buyers with closings from July, 1987, to March, 1989. The Taxpayer reported the sale proceeds from Tract 100 18-1 as ordinary income on their income tax returns.

The balance of the Beaumont property was resubdivided into 48 lots for single-family residences ("Exchange Property") with City approval being granted in June, 1986. Between January, 1987, and May, 1989, the Taxpayer's engineer prepared a tentative map, a final map, grading plans, improvement plans, and cost estimates for off-site improvements for the Exchange Property. However, the Taxpayer made no improvements to the Exchange Property.

In 1988, Gold Coast offered to purchase the Exchange Property from the Taxpayer. Rather than sell, The Taxpayer wanted to exchange under IRC § 1031 instead. The Taxpayer entered into an Exchange Agreement with Empire in April, 1989, contingent upon certain governmental approvals dealing with the finalization of the 48-lot subdivision for the Exchange Property. On May 16, 1989, Empire sold the Exchange Property to Gold Coast's successor in interest, Amerasian for $674,000. Empire received the proceeds of sale and recorded a $584,800 exchange credit in favor of the Taxpayer on its books. Simultaneously, Amerasian sold the Exchange Property to Elkhorn for $776,000. The Taxpayer timely replaced the Exchange Property with four (4) properties suitable for use as fast-food restaurant locations. Elkhorn recorded the final map for the 48 lots on the Exchange Property and its successor, Meadowlark Homes, eventually built out the subdivision in two (2) 24-lot phases. Meadowlark Homes realized a profit of about $630,000 on the sales of the 48 homes.

The Taxpayer realized a gain of approximately $428,000 on the sale of the Exchange Property which was reported as non-taxable under IRC § 1031. On audit, the IRS disallowed the transaction as an exchange and the Taxpayer filed a petition in the Tax Court. The Tax Court points out that the standard for qualifying for capital gains treatment differs from that under IRC § 1031. Capital gains treatment may not be obtained for property "held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." Exchange treatment may not be obtained for "property held primarily for sale." Thus, property may qualify for capital gains treatment while not qualifying for exchange treatment. Reg. Section 1. 1031(a) - I (b) provides that "[u]nproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale." The taxpayer's intention at the time of the disposition is what governs the result. "Primarily" has been defined in connection with the capital gains case, Malat v. Riddell 38') US 569 (1966), as meaning "of first importance" or "principally." In Bolker v. Commissioner 760 F2d 103 9 (9th Cir 1985), the court indicated that a taxpayer can satisfy the holding and intention requirements by owning the property without the intent to either liquidate the investment or to use it for personal pursuits.

The Taxpayer makes a series of arguments attempting to show that its intention with regard to the Exchange Property changed from its original intention (i.e., changed from build and sell intent) to a qualifying, investment intent, at the time of its disposition. The Taxpayer lists costs of off-site improvements, lowered profit potential, lack of housing market, governmental permit limitations, and the Taxpayer's shareholder's health as evidence of a change in intention. The Tax Court methodically examines each argument and rejects them. Meadowlark Homes actually built homes on the Exchange Property and realized a substantial profit and the Taxpayer continued its development business, building fast-food locations and residential housing tracts. The Taxpayer listed its business on its 1989 income tax returns as "real estate subdivider and developer" and not as "real estate operator and lessor of buildings." The Taxpayer recorded all expenditures in connection with the Exchange Property in the "work-in-progress" and "construction-in-progress" accounts and never made a reclassification as had been done with other properties.

Finally, the Tax Court distinguished the Paullus case since the operating corporation in Paullus was granted IRC § 1031 treatment and not the development corporation. Here, the development corporation is seeking IRC § 1031 treatment.

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