Attempts to Avoid Land Use Restrictions Betrayed Intention to Develop Property for Sale; Gain Was Ordinary, Not Capital

(Parker Tax Publishing September 2016)

The Eleventh Circuit affirmed a Tax Court holding that married taxpayers had improperly characterized gain from the sale of property they had been developing as capital gain rather than ordinary income. The court determined that the taxpayers' attempts to avoid costly land-use restrictions and their rezoning of the property indicated they had not abandoned their original intention to sell the property in the ordinary course of their business. The court declined to impose accuracy related penalties, finding that the taxpayers reasonably relied on a reputable accounting firm when preparing their returns. Boree v. Comm'r, 2016 PTC 341 (11th Cir. 2016).

Background

In November 2002, Gregory Boree, a former logger, doing business as Glen Forest, LLC (Glen Forest), acquired 1,892 acres of vacant real property in Baker County, Florida. In January 2003, Glen Forest submitted to the Baker County Planning and Zoning Department a conceptual map of a planned residential development called West Glen Estates, which would consist of more than 100 lots, to be developed and sold in multiple consecutive phases. The following month, the county adopted the proposal and rezoned the West Glen Estates property into ten-acre lots.

Beginning in late 2004, the Baker County Board of Commissioners adopted a series of land use restrictions that affected the development of West Glen Estates, including a temporary one-year moratorium on the development of non-plated subdivisions. In April 2005, the board adopted a requirement that all roads within subdivisions be paved. Following an unsuccessful attempt to request an exception from this requirement, Boree hired a land-use lawyer to pursue a higher-density development plan for West Glen Estates that would justify having to bear the roughly $7 million cost of paving the roads. Boree's intention was to "up-zone" the property to make it more appealing to other developers who might be interested in purchasing the property from him.

In April 2006, the attorney appeared before the Baker County Board to advise that Boree was planning a large-lot subdivision with associated commercial property to serve the neighborhoods, requesting that the county adopt a new, never before used designation of "rural commercial" for the proposed commercial property. The board ultimately adopted the new land use category. Around this time, Boree discovered that a successful Miami developer, Adrian Development (Adrian), was planning a large-scale development on a parcel of property adjoining the West Glen Estates property, and Boree negotiated a real estate purchase agreement whereby Adrian would purchase nearly all of the remaining unsold acres of West Glen Estates property. The sale closed in February 2007 for $9,608,670.

The Borees reported the gain ($8,578,636) from the sale to Adrian as a long-term capital gain on their 2007 tax return. The Borees hired the firm Austin Bovay, P.A. for tax matters and return preparation. They had been using Mr. Bovay, the founding CPA of the Bovay firm and a tax professor, since 1998.

In 2001, following an audit, the IRS issued the Borees a deficiency notice relating to their 2007 return, stating that the couple's income from selling the West Glen Estates property to Adrian should have been characterized as ordinary income, rather than as a capital gain. The IRS assessed a tax deficiency of $1,784,242. The IRS also imposed a $356,848 penalty under Code Sec. 6662(b)(2) for substantial understatement of income tax. The Borees disputed the penalty and the characterization of the gain and filed a petition with the Tax Court.

Tax Court Determines West Glen Estates Was Held for Sale in the Ordinary Course of Business

Under Code Sec. 1221(a)(1), the term "capital asset" generally means property held by the taxpayer, but does not include property held by the taxpayer primarily for sale to customers in the ordinary course of a trade or business. In determining whether property is held for sale in the ordinary course of business, considerations include (1) whether the taxpayer was engaged in a trade or business, and if so, what business; (2) whether the taxpayer was holding the property primarily for sale in that business; and (3) whether the sales contemplated by the taxpayer were "ordinary" in the course of that business.

Before the Tax Court, the Borees testified that Mr. Boree had purchased the West Glen Estates property intending primarily to hold it as an investment. The court declined to find this testimony credible, finding that Mr. Boree's true intent was to develop the property for sale in the ordinary course of its business. The court explained that the Borees consistently treated Glen Forest as a business, indicated by such activities as subdividing the West Glen Estates property, building a road, spending significant time and money on zoning activities, and continuing to pursue development activities after the board had adopted the moratorium on unpaved roads. The court noted that between 2002 and 2006, the Borees made frequent and substantial sales of property to customers, selling approximately 60 lots around the perimeter of the property. The court further ruled that the taxpayers were liable for the 20 percent Code Sec. 6662(b)(2) penalty because they had not established reasonable cause for the underpayment or that the return was prepared in good faith. The Borees appealed to the Eleventh Circuit.

Eleventh Circuit Affirms Ordinary Income Treatment for Sale of Property to Adrian

Before the Eleventh Circuit, the Borees conceded that, prior to the enactment of the county land use restrictions, Glen Forest held the West Glen Estates property for sale in its ordinary course of business of developing a subdivision. The couple argued, however, that they abandoned all intent to develop the property after the paving requirements were imposed, comparing their case to others in which an "adverse government action" rendered the taxpayer's original business purpose futile. The couple cited to Ridgewood Land Co. v. Comm'r, 477 F.2d 135 (5th Cir. 1973), in which a taxpayer acquired property intending to develop it for sale to customers, but after a state authorized condemnation proceedings against the property for use in the construction of a highway, the taxpayer sold the undeveloped land to an adjacent landowner who was negotiating to sell land to the state. In that case, the Fifth Circuit found that the taxpayer's purpose in holding the property had changed from ordinary course of business to investment because any development of the land would have been futile due to the impending condemnation.

The Eleventh Circuit found that case was distinguishable from the instant case, stating an exercise of the government's eminent domain power, unlike an ordinance mandating the paving of roads, deprives a landowner of all potential uses of his property except selling the property to the government. The restrictions on the Borees did not foreclose all development of property in Baker County, the court said; potential developers just had to be financially able to pave internal and connecting roads. As such, the court determined that "adverse government action" cases were of no help to the Borees.

The court also observed that the taxpayers' actions in the years 2004 through 2007 betrayed their true intent to continue to develop the property. When compliance with the land use restrictions threatened to render the original West Glen Estates development plan unprofitable, the court stated, Mr. Boree did not passively hold the property in hopes that he could sell it to a buyer at an attractive price. Rather, he first sought to obtain exceptions to the paving requirements so that his subdivision could proceed. When that was unsuccessful, the court noted, he hired a land-use attorney and applied to rezone the property for a more densely zoned residential and commercial development that would fund his costs of complying with the new county paving requirements, and continued to pursue this strategy even after he entered into the sales agreement with Adrian in April 2006. Such evidence of strategic and thorough involvement in pursuit of developing the property, the court stated, indicated that the Borees were holding the property for sale in the ordinary course of business right up until they sold it to Adrian, and not merely as an investment property.

Eleventh Circuit Declines to Impose Substantial Understatement Penalty

The Borees' second request on appeal was for the reversal of the Tax Court's imposition of the substantial understatement penalty. The Eleventh Circuit noted that while Code Sec. 6662 imposes a 20 percent accuracy-related penalty on taxpayers for any understatement of income tax, under Code Sec. 6664(c)(1) the penalty does not apply if the taxpayer shows that there was a reasonable cause for, and that the taxpayer acted in good faith with respect to, the understatement. The court stated that a taxpayer can meet this burden by showing that he reasonably relied in good faith on the advice of an independent professional, such as a tax advisor, lawyer, or accountant, as to the transaction's tax treatment.

The Eleventh Circuit noted that the Tax Court did not elaborate on why it determined that the Borees had not established reasonable cause with respect to not being liable for the penalty or had not shown that their tax return was prepared in good faith. The court found that the record did not support the Tax Court's conclusion. The court observed that Mr. Boree, a former logger with no accounting experience, had relied on the Bovay accounting firm since 1998, a firm that enjoyed a strong reputation due in part to Mr. Bovay serving as a tax professor. The court noted that Mrs. Boree personally provided the Bovay firm with the information and records she kept relating to all of the land transactions, indicating that the Borees engaged in appropriate efforts to assess their tax liability. The court observed that there was no indication in the record that the Borees withheld any information from their accountant, and noted that the IRS conceded that the Borees did not provide any false information. Although the Borees' accountant prepared the 2007 tax return claiming deductions of $46,360 for business expenses while claiming a capital gain from the same activity, the court stated that it was reasonable for the Borees, who were untrained in tax matters, to have relied in good faith on that decision. The Eleventh Circuit held that the Tax Court clearly erred in finding that the Borees were liable for the penalties.

For a discussion on the tax treatment of gains on the sale of property held for sale in the ordinary course of business, see Parker Tax ¶111,105.05.

For a discussion of the abatement of penalties due to reasonable cause and a taxpayer acting in good faith, see Parker Tax ¶262,127.

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.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com