T.C. Memo. 2018-21
UNITED STATES TAX COURT
SUGAR LAND RANCH DEVELOPMENT, LLC, SUGAR LAND ADVISORS, LLC, TAX MATTERS PARTNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5835-16. Filed February 22, 2018.
George W. Connelly, Jr., and Rita Renee Huey, for petitioner.
Candace M. Williams and Carol Bingham McClure, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
THORNTON, Judge: Pursuant to section 62231 respondent issued a notice
of final partnership administrative adjustment (FPAA) for 2012 to Sugar Land
1 All section references are to the Internal Revenue Code in effect at all relevant times, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated. Monetary amounts are rounded to the nearest dollar. Acreages are rounded to the nearest tenth of an acre. -2-
[*2] Advisors, LLC (SLA), the tax matters partner of Sugar Land Ranch
Development, LLC (SLRD).2 The FPAA recharacterizes net gains from SLRD’s
sales of two parcels of real property in 2012 from capital gains to ordinary income
(all other adjustments are computational). Petitioner filed a timely petition
contesting these adjustments.
FINDINGS OF FACT
SLRD was established as a Texas limited liability company on February 27,
1998.3 It was formed principally to acquire contiguous tracts of land in Sugar
Land, Texas, just southwest of Houston, and to develop that land into single-
family residential building lots and commercial tracts. On or about March 18,
1998, SLRD purchased approximately 883.5 acres. An additional 59.1 acres was
conveyed to SLRD on or about November 24, 1998. We sometimes refer to all
this acreage collectively as the property.
2 When the petition was filed, Texas was the principal place of business for SLRD. 3 SLRD is owned by Sugar Land Holding Corp. (SLHC) (85%) and SLA (15%). SLHC is owned by Lawrence Wong and Rocky Lai. SLA is owned by Omni Investments LP (33.33%) and Larry Johnson (66.67%). Omni Investments LP is owned by Larry Johnson’s spouse Suzanne Johnson (99.9%) and Omni Investments GP, LLC (0.1%). Omni Investments GP, LLC is owned by Larry Johnson (33.33%) and Suzanne Johnson (66.67%). -3-
[*3] The property had formerly been an oil field and was west of, and adjacent
to, the Riverstone Master-Planned Community (Riverstone Community), which
was being developed by parties related to SLRD. SLRD’s original plan was to
clean up the property and subdivide it into residential units for inclusion in the
Riverstone Community. To that end, between 1998 and 2008 SLRD capped oil
wells, removed oil gathering lines, did some environmental cleanup, built a levee,
and entered into a development agreement with the City of Sugar Land, Texas,
which specified the rules that would apply to the property, should it be developed.
SLRD sold or otherwise disposed of relatively small portions of the
property between 1998 and 2008. The 824.7 acres SLRD continued to own as of
2008 were contiguous but divided by three easements. The first easement, the
HLP easement,4 ran generally from north to south near the eastern end of the
property. The second easement was for a planned road, University Boulevard, and
ran from east to west. Finally, there was an easement for a levee running generally
from north to south near the western end of the property.5
4 The record does not disclose what “HLP” stands for, though we note that it resembles the acronym for Houston Lighting & Power. 5 By 2016 SLRD had sold or conveyed all the land east of the HLP easement, apparently to related parties. The tax treatment of the parcels east of the HLP easement is not in dispute, although respondent argues that the characterization of (continued...) -4-
[*4] The land west of the HLP easement consisted of four large parcels. The
westernmost parcel comprised all the land below the levee, i.e., on the river side of
the levee; it was eventually conveyed to the City of Sugar Land.6 The remaining
three parcels (comprising all the acreage between the levee and the HLP easement
--a total of approximately 580.2 acres) were sold to a major homebuilder, Taylor
Morrison of Texas, Inc. (Taylor Morrison), in 2011 and 2012. We will refer to
these parcels as TM-1, TM-2, and TM-3 (collectively, the TM parcels).7
Late in 2008 the managers of SLRD--Larry Johnson and Lawrence Wong--
decided that SLRD would not attempt to subdivide or otherwise develop the
property it held. From their long experience in the real estate development
business, they believed that SLRD would be unable to develop, subdivide, and sell
5 (...continued) the gains or losses from those sales is relevant to determining the tax treatment of the sales which are at issue. 6 This parcel appears to have been approximately 110 acres and seemingly could not be developed because it was below, i.e., on the river side of, the levee. Other small portions of the property adjacent to the levee were also conveyed to the City of Sugar Land. 7 TM-1 was 110.5 acres. It abutted the HLP easement to the east and ran from University Boulevard north to the property line. TM-2 was 396 acres and comprised the entire area south of University Boulevard between the levee and the HLP easement. TM-3 was 73.7 acres. It abutted TM-1 to the east and the levee to the west and ran from University Boulevard north to the property line. -5-
[*5] residential and commercial lots from the property because of the effects of the
subprime mortgage crisis on the local housing market and the scarcity or
unavailability of financing for housing projects in the wake of the financial crisis.
Instead, Messrs. Johnson and Wong decided that SLRD would hold the property
as an investment until the market recovered enough to sell it off. These decisions
were memorialized in a “Unanimous Consent” document dated December 16,
2008 (signed by Messrs. Johnson and Wong), as well as in an SLRD member
resolution adopted on November 19, 2009, to further clarify SLRD’s policy.
Between 2008 and 2012 the TM parcels “just sat there” (as Mr. Johnson
credibly testified); that is, SLRD did not develop those parcels in any way. SLRD
did not list the TM parcels with any brokers or otherwise market the parcels
because SLRD’s managers believed that there was no market for large tracts of
land on account of the subprime mortgage crisis.
In 2011 Taylor Morrison approached SLRD about buying TM-1 and TM-3
(i.e., the 184.2 acres between the levee and the HLP easement and north of
University Boulevard). Taylor Morrison ultimately decided to buy all three TM
parcels. SLRD sold TM-1 to Taylor Morrison in 20118 and TM-2 and TM-3 to
8 The 2011 sale is not at issue in this case. Respondent asserts that SLRD reported the gains from the 2011 sale as ordinary income although the record is (continued...) -6-
[*6] Taylor Morrison on December 21 and 28, 2012, respectively. SLRD and
Taylor Morrison executed two sale contracts for this purpose. One sale contract
(TM-3 contract), which was executed by SLRD and Taylor Morrison, provided for
the sale of TM-1 and TM-3 in 2011 and 2012, respectively. The second sale
contract (TM-2 contract), which was executed by SLRD, Taylor Morrison, and
Hillsboro Estates, LLC (a third party apparently related to SLRD), provided for
the sale of TM-2 in 2012 and for the sale of a property directly to the south of TM-
2 (which was owned by Hillsboro Estates, LLC).
The TM-2 and TM-3 contracts each called for Taylor Morrison to pay a
lump sum to SLRD in 2012 for the largely undeveloped TM-2 and TM-3 parcels.
The TM-2 contract also provided that Taylor Morrison was obligated to pay SLRD
2% of the final sale price of each future home eventually developed and sold out
of TM-2. The TM-2 contract specified that each 2% payment would accrue when
each home sale closed. SLRD was also to receive $3,500 for each plat recorded
on TM-2. Unlike the TM-2 contract, the TM-3 contract did not provide for a 2%
per-home payment, but did provide for a payment of $2,000 for each plat recorded
on TM-3. The TM-2 and TM-3 contracts also listed other development
8 (...continued) inconclusive on this point. -7-
[*7] obligations for which the parties were responsible. These development
obligations fell almost entirely on Taylor Morrison.
No part of the payments received by SLRD from Taylor Morrison in 2012
included either the 2% per-home or per-plat fees provided for in the TM-2 and
TM-3 contracts. That is, the net gain at issue in this case represents only the lump-
sum payments SLRD received in 2012 for the largely undeveloped TM-2 and TM-
3 parcels. Respondent has not argued, nor does the record suggest, that the lump
sums SLRD received in 2012 represent payment for anything other than the fair
market value of the largely undeveloped TM-2 and TM-3 parcels.
After commencing the sale of the TM parcels, SLRD decided to close out its
property holdings by conveying the remainder of its property to related parties
(except for land that was eventually conveyed to the City of Sugar Land for no
consideration and except for a one-acre parcel that appears to have been sold to a
county) in four sales in 2012, 2013, 2014, and 2016. These parcels were all to the
east of the HLP easement and were 86.9, 12.1, 32, and 2.2 acres, respectively.
These parcels were ultimately included in the Riverstone Community and appear
to have been developed by parties related to SLRD.
The record contains SLRD’s Forms 1065, U.S. Return of Partnership
Income, for 2005, 2006, and 2012. On these three returns, SLRD stated that its -8-
[*8] principal business activity was “Development” and that its principal product
or service was “Real Estate”. On its 2012 Form 1065 SLRD reported an
$11,086,640 capital gain from its sale of the TM-2 parcel and a $1,569,393 capital
loss from its sale of the TM-3 parcel. In the FPAA respondent determined that the
aggregate net income from these two transactions should be taxed as ordinary
income.
OPINION
In this proceeding, we review under section 6226 respondent’s adjustments
to SLRD’s 2012 partnership return.9 The Commissioner’s adjustments in an
FPAA are generally presumed correct, and the taxpayer bears the burden of
proving those adjustments erroneous. Rule 142(a); Republic Plaza Props. P’ship
v. Commissioner, 107 T.C. 94, 104 (1996).
The issue presented is whether SLRD’s sales of the TM-2 and TM-3 parcels
should be treated as giving rise to capital gains or ordinary income. A capital
9 Our jurisdiction is limited to determination of partnership items, allocation of partnership items among the partners, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partner- ship item. Sec. 6226(f). The only issue in this case is whether net proceeds of two of SLRD’s sales in 2012 should be treated as capital gains or ordinary income. Items of gain of the partnership are partnership items. Sec. 301.6231(a)(3)- 1(a)(1)(i), Proced. & Admin. Regs.; see sec. 6231. Therefore, we have jurisdiction over the issue presented in this case. -9-
[*9] asset is “property held by the taxpayer (whether or not connected with his
trade or business)” but excludes, among other things, “inventory” and “property
held by the taxpayer primarily for sale to customers in the ordinary course of his
trade or business”. Sec. 1221(a)(1).
The Court of Appeals for the Fifth Circuit--the court to which this case is
appealable absent a stipulation to the contrary, see sec. 7482(b)(1)(E)--has held
that the three principal questions to be considered in deciding whether gain is
capital in character are: (1) “[W]as taxpayer engaged in a trade or business, and, if
so, what business?” (2) “[W]as taxpayer holding the property primarily for sale in
that business?” And (3) “[W]ere the sales contemplated by taxpayer ‘ordinary’ in
the course of that business?” Suburban Realty Co. v. United States, 615 F.2d
171, 178 (5th Cir. 1980).
The Court of Appeals for the Fifth Circuit has also indicated that various
factors may be relevant to these inquiries: the frequency and substantiality of
sales of property; the taxpayer’s purpose in acquiring the property and the duration
of ownership; the purpose for which the property was subsequently held; the
extent of developing and improving the property to increase the sales revenue; the
use of a business office for the sale of property; the extent to which the taxpayer
used advertising, promotion, or other activities to increase sales; and the time and - 10 -
[*10] effort the taxpayer habitually devoted to the sales. See id. at 178-179; see
also Bramblett v. Commissioner, 960 F.2d 526, 530-531 (5th Cir. 1992), rev’g
T.C. Memo. 1990-296; Biedenharn Realty Co. v. United States, 526 F.2d 409, 415
(5th Cir. 1976); United States v. Winthrop, 417 F.2d 905, 910 (5th Cir. 1969);
Maddux Constr. Co. v. Commissioner, 54 T.C. 1278, 1284 (1970). Frequency and
substantiality of sales is the most important factor. Suburban Realty, 615 F.2d at
178.
I. Capital Character of Net Gains From Sales
The parties agree that SLRD was formed to engage in real estate
development--specifically, to acquire the property and develop it into single-
family residential building lots and commercial tracts. The record supports this
conclusion: SLRD’s tax returns, the development agreement, SLRD’s formation
documents, and the testimony of Messrs. Johnson and Wong all clearly show that
SLRD originally intended to be in the business of selling residential and
commercial lots to customers.
But the evidence also clearly shows that in 2008 SLRD ceased to hold its
property primarily for sale in that business and began to hold it only for
investment. SLRD’s partners decided not to develop the property any further, and
they decided not to sell lots from those parcels. This conclusion is supported by - 11 -
[*11] the highly credible testimony of Messrs. Johnson and Wong and by the 2008
unanimous consent and the 2009 member resolution. In fact, from 2008 on SLRD
did not develop or sell lots from those parcels (and the evidence does not suggest
that SLRD ever sold even a single residential or commercial lot to a customer at
any point in its existence). Respondent concedes that SLRD never subdivided the
property.
More particularly, when the TM parcels were sold, they were not sold in the
ordinary course of SLRD’s business: SLRD did not market the parcels by
advertising or other promotional activities. SLRD did not solicit purchasers for
the TM parcels, nor does any evidence suggest that SLRD’s managers or members
devoted any time or effort to selling the property; Taylor Morrison approached
SLRD. Most importantly, sale of the TM parcels was essentially a bulk sale of a
single, large, and contiguous tract of land (which was clearly separated from any
other properties by the HLP easement and the levee) to a single seller--clearly not
a frequent occurrence in SLRD’s ordinary business.
Because the Taylor Morrison parcels were held for investment and were not
sold as part of the ordinary course of SLRD’s business, we hold that net gains
from the sales of TM-2 and TM-3 were capital in character. - 12 -
[*12] II. Respondent’s Arguments
Respondent argues that the extent of development of the TM parcels shows
that these properties were held primarily for sale in the ordinary course of SLRD’s
business. We are not persuaded. It is clear that from 1998 to sometime before
2008 SLRD developed the property to a certain extent. But it is also clear that in
2008 SLRD’s managers decided not to develop those parcels into a subdivision
and decided not to market the land as it ordinarily would have. As the Court of
Appeals for the Fifth Circuit held in Suburban Realty, 615 F.2d at 184, a taxpayer
is “entitled to show that its primary purpose changed to, or back to, ‘for
investment.’” SLRD has made such a showing. Any development activity that
occurred before the marked change in purpose in 2008 (including whatever
respondent thinks was reported on SLRD’s 2005 and 2006 Forms 1065) is largely
irrelevant.
Respondent also argues that the frequency of sales, along with the nature
and extent of SLRD’s business, shows that gains from the sale of the TM parcels
should be ordinary in character. But SLRD’s sales were infrequent, and the extent
of SLRD’s business was extremely limited. After 2008 SLRD disposed of its
entire property in just nine sales over eight years (not counting conveyances to the
City of Sugar Land, for which SLRD received no consideration). Cf. Byram v. - 13 -
[*13] United States, 705 F.2d 1418, 1425 (5th Cir. 1983) (holding that although
the taxpayer made 22 sales over a three-year period, the taxpayer did not hold the
property for sale). Moreover, the TM parcels had not been developed into a
subdivision when they were sold, and little or no development activity occurred on
those parcels for at least three years before sale.
In any event, respondent’s description of the pattern of sales after 2008 is
inconsistent with the record. The TM parcels were on the western side of the HLP
easement and were all sold to Taylor Morrison in a three-part transaction
beginning in 2011. All of the other parcels sold by SLRD, i.e., parcels other than
the TM parcels, were on the east side of the HLP easement and appear to have
been conveyed to related parties (with the exception of a one-acre parcel sold to a
county). The balance of the property was conveyed for no consideration (rather
than sold) to the City of Sugar Land at various times. In sum, leaving aside the
land that was conveyed for public use, after 2008 SLRD sold all of the
undeveloped property west of the HLP easement (well over half its property
holdings) in a single extended transaction to a single buyer, Taylor Morrison, and
sold the remainder (all of which was to the east of the HLP easement) to related
entities. - 14 -
[*14] Respondent seems to suggest that we should impute to SLRD development
activity which he says was performed on the eastern parcels by related parties.
Respondent has not pointed us to legal authority or any evidence in support of this
position. The caselaw appears to be to the contrary. See Bramblett v.
Commissioner, 960 F.2d at 533-534 (rejecting argument that activities of
corporation in selling and developing land should be attributed to partnership
whose partners held ownership interests in the corporation); Phelan v.
Commissioner, T.C. Memo. 2004-206 (similar). But even if we were to assume
for the sake of argument that SLRD had substantial development activity on, or
active and continuous sales from, the eastern parcels (by imputation or otherwise),
nevertheless--in the absence of a connection between the eastern parcels and the
TM parcels--we are not persuaded that the bulk sale of the TM parcels would have
been in the ordinary course of SLRD’s alleged development business, considering
that all development activity had been halted on the TM parcels at least three years
before the sales at issue and that the TM parcels were never developed into a
subdivision by SLRD. As the Court of Appeals for the Fifth Circuit noted in
Suburban Realty, 615 F.2d at 179 n.24, “if a taxpayer who engaged in a high
volume subdivision business sold one clearly segregated tract in bulk, he might
well prevail in his claim to capital gain treatment on the segregated tract.” That is - 15 -
[*15] precisely what happened here. The TM parcels were clearly segregated from
the other parcels by the levee and HLP easement and were sold in bulk to a single
buyer.
Respondent argues that there was a connection between the TM parcels and
the parcels east of the HLP easement: (1) they were all covered by the same
development agreement with the City of Sugar Land; (2) Taylor Morrison agreed
to develop the TM parcels in accordance with various restrictions in the land sale
deal; and (3) SLRD was to receive certain payments whenever certain conditions
were met.
We think, however, that the facts respondent points out are either irrelevant
to the adjustment in the FPAA or consistent with investment intent. For example,
there would have been no reason to undo or even modify the development
agreement after deciding not to develop the TM parcels. There seems to be little
doubt that the highest and best use of this land was for development into
residential and commercial lots. Any buyer would likely have been a developer of
some kind. Maintenance of the development agreement was therefore consistent
with both development intent and investment intent. Cf. Suburban Realty, 615
F.2d at 178-179 (“[S]tanding alone, some degree of development activity is not
inconsistent with holding property for purposes other than sale.”). - 16 -
[*16] As for the restrictions, we conclude that they were directed at ensuring that
Taylor Morrison assumed any obligations or liabilities relating to the TM parcels
and at ensuring that Taylor Morrison’s actions would not decrease the value of the
Riverstone Community as a whole. Such restrictions are not inconsistent with
investment intent--a seller of property, whether an investor or a dealer, might
reasonably draft the sale agreement so as to ensure that it would not retain
personal liability with respect to the property or to ensure that the buyer would not
decrease the value of adjoining properties the seller continues to hold.
Finally, the additional payments provided for in the TM-2 and TM-3
contracts are largely irrelevant to the adjustment at issue in this case. While it is
true that the TM-2 and TM-3 contracts provided for various additional payments
when a plat was recorded or when a home sale closed, the nature of these
additional payments does not illuminate the character of the net gain at issue in
this case. Respondent has not argued, nor does the record suggest, that either the
lump sums paid in 2012 for the TM-2 and TM-3 parcels, or any of the additional
payments, were incorrectly priced in the land sale contract. Additionally, it is
clear from the record that the payments received by SLRD in 2012 for the TM-2
and TM-3 parcels did not include any additional per-lot or per-home payments
(nor does the record support a conclusion that any additional per-lot or per-home - 17 -
[*17] payments accrued in 2012). Consequently, even if we were to assume that
the additional payments would be treated as ordinary income if and when they
should accrue, that circumstance would shed little light on the character of the net
gain recognized in 2012 because the 2012 net gain included no such additional
payments. We also note that nothing in the land sale agreement (or in the record
generally) suggests that SLRD was under any obligation to develop the TM
parcels after the sale.
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.” See Suburban Realty, 615 F.2d at 181. Considering the record as a
whole, we are inclined to believe that these stock descriptions were inadvertently
carried over from earlier returns.
Finally, on brief respondent asserts in passing that a stipulated schedule of
SLRD’s capitalized expenses shows that SLRD “continued to incur development
expenses up until it sold the Taylor Morrison land.” But the record as a whole
clearly shows that the TM parcels were not developed between 2008 and the sale
to Taylor Morrison, and respondent concedes that SLRD never subdivided the TM - 18 -
[*18] parcels (or any of its property). Also, most of the post-2008 expenditures on
the schedule of capitalized expenditures are either consistent with investment
intent or appear to have been incurred with respect to parcels other than the TM
parcels.10 For these reasons we accord the listing of capitalized expenses little
weight--certainly not enough to override the factors in SLRD’s favor, such as the
infrequency of sales by SLRD (which is the most important factor in our analysis,
see Suburban Realty, 615 F.2d at 178).
Therefore, on the basis of all the evidence, we conclude that SLRD was not
engaged in a development business after 2008 and held the TM-2 and TM-3
properties as investments. Accordingly, we hold that SLRD properly
characterized the gains and losses from the sales of these properties as income
from capital assets.
To reflect the foregoing,
Decision will be entered for petitioner.
10 There are two expenditures in 2011 and 2012 ($340,000 and $1,723,835, respectively) which are listed as “Management/Development Fees”. Neither party has offered an explanation for these fees, but considering that similar fees were paid consistently each year from 1999 to 2006, and then were not paid again until 2011 and 2012 (when Taylor Morrison offered to purchase the TM parcels), it seems most likely that the 2011 and 2012 fees (if they even related to the TM parcels) were incurred as part of the sale process rather than as part of a continuing effort to develop the TM parcels.