I remember trying to explain the dealer versus investor concept to a would-be real estate entrepreneur.  I asked him whether he was holding the property for sale. He kind of looked at me and smiled and said “Everything is for sale. It just depends on how much.”. If there is any ambiguity it is easy to know what the answer is after the fact. If there was a big gain relative to expenses then you were an investor. If there was a loss, then you were a dealer. Unfortunately, you really are not supposed to practice that way. I am going to assume that you want investor status and that you are blessed with a gain. What can you do to make sure the IRS respects your investor status? 

The Case Law

There is a significant amount of case law on this issue. It may be instructive to look at losing cases, to find mistakes to avoid. There is a problem with that though. There are an infinite number of ways that people can screw up. So as with my study of the hobby loss phenomenon, I believe that it is best to focus on winning cases both in planning and in fighting an audit.

When it comes to representing your client at an audit, I tend to think of case law like a card game. Not poker or bridge or any other game that is played with a 52-card deck. Rather I am thinking of Magic the Gathering where each player builds their own deck out of a universe of over 20,000 cards. Make sure you have a stronger deck of winning cases than your adversary.

One of the best cases to lean on to establish investor status is the Timothy Phelan case.

The Phelan Story

The Phelan brothers were involved in both real estate development and construction. Along with their partner, they formed a single purpose entity (Jackson Creek Land Corporation-JCLC) to own the particular tract of land in question (which they designated Jackson Creek). JCLC was considered a partnership for income tax purposes. The court found the formation and operation of this single purpose entity very significant. It also noted that the Phelan’s real estate business conducted through other entities concerned commercial real estate rather than residential real estate projects, such as Jackson Creek.

The transactions involved in the Jackson Creek project were rather complex. The property was part of a larger tract that had been acquired by a developer (the Regency Group) in the 1980’s. In 1987 the developer entered into an agreement with Triview. Triview was a political subdivision of the state of Colorado, with the authority to levy taxes, issue bonds and assess fees. Regency, Triview and the adjacent town of Monument entered into an agreement obligating each of them to make infrastructure improvements and in the case of Regency pay fees. Monument annexed the land of the project to become part of the town, but the various agreements stayed in force. Shortly, thereafter Regency filed for bankruptcy.

Phelan acquired the property from J&L Higby trust which had acquired it form Regency. Shortly after acquiring the property in 1994, Phelan deeded the land to JCLC. The transfers were all subject to the various infrastructure agreements.  

JCLC performed a Preliminary Geological Investigation on the land and finalized a development plan with Monument that allowed for the commencement of construction.

JCLC first capital gain transaction was in 1998 when it agreed to sell 102 acres (a bit less than 10% of the acreage) to Elite properties in three separate closings. JCLC agreed to cause Triview to make certain improvements and to make others itself. All the work ended up being done by Triview, including the portion that JCLC was supposed to do itself.

The next capital gain transaction was with Vision Development Corporation, an entity owned by the same people who owned JCLC in the same proportion. Vision was formed to do development work on 46.5 acres in order to prepare it for sale to a home builder. The plot now thickens. Triview it develops is in default on its bonds. Through a series of transactions involving other entities controlled by the Phelans, the bonds were refinanced, and additional bonds were purchased. Presumably this is what allowed Triview to complete the infrastructure improvements it was obligated to perform…There was, however, no direct link between the two events.

Finally, Vision and JCLC entered into a revolving loan agreement which would allow Vision to make improvements on a 184 acre parcel for sale to homebuilders.

Looking at it through the jaundiced eye of a revenue agent, it would appear that three people got together, bought some land cut it into pieces and directly or indirectly made substantial improvements. The court, however, ruled that the sales by JCLC produced capital gains.

Why Phelan Got Capital Gains Treatment

JCLC was a partnership. As long as its existence is respected the nature of its purpose in holding is evaluated at the partnership level. In looking at JCLC’s purpose the court considered the following factors:

1. JCLC was formed with the investors knowing that the various pieces to allow its ultimate development were basically in place and expected the property to appreciate;

2. The offer from Elite was unsolicited;

3. None of the owners of JCLC held broker’s licenses;

4. JCLC did not advertise or hire representatives;

5. Although JCLC promised Elite that Triview would do certain things, this only gave Elite recourse against JCLC;

6. JCLC had no employees. Although it was obligated to make improvements if Triview did not;

7. The risks and rewards associated with the purchase of bonds by related parties were not directly tied to the Jackson Creek project;

8. With respect to the sale to Vision, even though JCLC owners were not personally liable, they protected their interest in the balance of the land by carving off the portion going to Vision. This was a valid non-tax motivation for the transaction;

9. The four-year holding period and limited number of sales.

The essence of the Phelan decision is having an investment entity that is passive and having development activity in other entities. This implies that not all the profits can be capital gains. Each entity has to stand on its own.

Another Decision

Sometimes property is acquired with high hopes of relatively quickly developing and selling it. And then stuff happens converting the holding entity into an investment entity. That was the story with Sugar Land Ranch Development LLC. The decision was in favor of the taxpayer, but there is an important practice pointer included in that opinion.

“Next, respondent points out that on its 2012 Form 1065 SLRD listed its principal business activity as “Development” and its principal product or service as “Real Estate”. Although this circumstance may count against petitioners to some limited degree, we believe that these statements “are by no means conclusive of the issue.”

My experience is that those question about principal business activity might have some thought put into them in the initial return, but nobody ever thinks about them again as they are rolled over from one year to the next. Who cares? Tax Court judges care. Fortunately for Sugar Land, Judge Thornton did not care much, but it could have gone the other way. Reilly’s Fourth Law of Tax Planning – Execution isn’t everything, but it’s a lot.

Conclusion

A significant challenge in this area can be getting your clients to commit to what they have in mind. If there is an expectation that property may be held for a while, then set up an investment entity to own it. Have a separate entity that performs any development activity. Try to make sure that the separate entities are respected and run their own transactions. Don’t let bills be paid out of the wrong entity and fix it with journal entries. And, if challenged, have the Phelan card near the top of your deck.

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