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T.C. Memo. 1998-302
UNITED STATES TAX COURT
NEAL T. BAKER ENTERPRISES, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 20372-95.
Filed August 19, 1998.
John K. Mirau, for petitioner.
Lisa Kuo, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WRIGHT, Judge: Respondent determined a deficiency in
petitioner's Federal income tax for the tax year ended March 31,
1990 (1989 taxable year), in the amount of $145,794.
This case involves the question of whether petitioner may
defer recognition of gain from the disposition of certain real
- 2 property under section 1031.1
More specifically, we must decide
whether petitioner held the exchanged real property primarily for
sale so that the gain is taxable in the 1989 taxable year.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein.
Petitioner's principal office was located
in San Bernardino, California, at the time it filed its petition.
Petitioner filed a U.S. Corporation Income Tax Return, Form 1120,
for the taxable year 1989, with the Director, Internal Revenue
Service Center, Fresno, California.
Petitioner used a fiscal
year ending March 31.
Petitioner was incorporated on September 18, 1957, under the
laws of the State of California.
From petitioner's inception to
the taxable year 1991, Neal T. Baker (Mr. Baker), as president
and director of petitioner,2 controlled and directed its
operations.
Additionally, starting in 1987, Mr. Baker was
petitioner's chief financial officer.
During the period from
1
All section references are to the Internal Revenue Code
in effect for the year at issue, unless otherwise indicated. All
Rule references are to the Tax Court Rules of Practice and
Procedure.
2
At times during the period 1978 to 1991, Neal T. Baker
also served as treasurer and secretary of petitioner.
Besides his role with petitioner, Mr. Baker was a charter
member of the Business Bank of California. As a chairman of the
bank's loan committee, Mr. Baker reviewed construction loans.
- 3 1978 to 1991, Carol Baker served as petitioner's vice president
and director.3
At times during the period from 1978 to 1991, one
other person served in the position of treasurer, secretary,
chief financial officer, or director.
Petitioner's articles of incorporation, filed September 13,
1957, listed the following purposes:
(a)
PRIMARY PURPOSE--To operate drive-in restaurants,
SECONDARY PURPOSE--To construct and sell buildings and,
(b) To manufacture, fabricate, assemble, to take, purchase
and otherwise acquire, own, hold, use, sell, assign,
transfer, exchange, lease, and otherwise dispose of, and to
invest, trade, deal in and with goods, wares and merchandise
and supplies and all other personal property of every class
and description.
(c) To purchase, acquire, own, hold, use, lease (either as
lessor or lessee), grant, sell, exchange, subdivide,
mortgage, convey in trust, manage, improve, construct,
operate and generally deal in any and all real estate,
improved or unimproved, stores, office buildings, dwelling
houses, apartment houses, hotels, manufacturing plants and
other buildings, and any and all other property of every
kind or description, real, personal and mixed, and
wheresoever situated, either in California, other states of
the United States, or foreign countries.
*
*
*
*
*
*
*
In 1969, petitioner engaged in a corporate restructuring in
which Baker's Burger was incorporated to conduct petitioner's
fast-food business.
According to the minutes of the special
meeting of the Board of Directors on October 16, 1969:
The Chairman [Mr. Baker] explained that Baker's Burgers,
Inc., a California corporation, was formed to conduct the
drive-in hamburger and Taco Stand business separate and
apart from the contracting business, both of which were
3
Carol Baker was also petitioner's secretary in 1978,
1979, and 1980.
- 4 formerly carried on by Neal T. Baker Enterprises. He
further stated that the two businesses were for all
practical purposes totally unrelated, and that it had become
necessary to conduct the two businesses separately in order
to facilitate flexibility, expansion, cost control, proper
management and the raising of capital.
Mr. Baker testified that the restructuring was in part to prepare
Baker's Burgers, Inc., for a possible public offering.
Petitioner transferred assets (valued at $36,000) to Baker's
Burgers, Inc., in exchange for stock of Baker's Burgers, Inc.
As
a result of the restructuring, petitioner held real estate
holdings, which included buildings for fast-food locations (which
were leased to Baker's Burger, Inc.), real estate held for
investment, and real estate held for development.
After 1969,
petitioner continued to construct additional fast-food locations,
and also continued to contract with third parties for the
construction of residential properties.
In regard to its construction operations, petitioner had a
contractor's license with the State of California, but it did not
have any contracting equipment.
done through subcontractors.
All the contracting work was
Petitioner recorded the work done
(payments) by its subcontractors under work-inprogress/construction in-progress accounts.
realtors to sell its properties.
Petitioner used
Petitioner recognized revenue
from these sales when escrow closed.
On February 1, 1983, petitioner filed its restated articles
of incorporation with the State of California, providing the
- 5 purpose "to engage in any lawful act or activity for which a
corporation may be organized under the General Corporation Law of
California other than the banking business, the trust company
business or the practice of a profession permitted to be
incorporated by the California Corporations Code."
Beaumont Property--Tract No. 10018
On March 10, 1978, petitioner purchased from the Simoffs
vacant land in Beaumont, California (Beaumont Property), for
$155,000.
Beaumont Property is bounded on the west by
Pennsylvania Avenue, the east by Cherry Avenue, the south by 10th
Street, and the north by another lot north of 11th Street.
When
petitioner purchased the Beaumont Property, the property was
zoned R-1 for single-family residential use.
Petitioner never
made an application to have the Beaumont Property rezoned to R-4
multi-family residential use.
From 1978 through 1989, petitioner hired three engineering
firms to process tentative maps on the Beaumont Property:
(1) H. D. Marcell; (2) Wes Engineering; and (3) Garner, Troy &
Associates, Inc.
Petitioner's purchase of the Beaumont Property was
contingent upon the Tentative Subdivision Map being approved by
the City of Beaumont Planning Commission (Planning Commission).
At that time, there was a subdivision map prepared by H. D.
Marcell for the Simoffs.
This tentative map proposed to
- 6 subdivide the property into 48 lots for the construction of
single-family residential houses.
On June 22, 1978, the
tentative subdivision map was approved by the Planning
Commission.
The map was assigned Tract No. 10018.
On April 23, 1979, petitioner's Board of Directors
authorized the preparation and filing of an application to the
Real Estate Commissioner of the State of California for a Public
Report in connection with the subdivision and sale of real
property on the 48 lots of the Beaumont Property.
Later, petitioner hired Wes Engineering to prepare a revised
tentative map for Tract No. 10018.
The map proposed 56 single-
family residential lots, and was resubmitted to the city of
Beaumont on February 28, 1980.
In July 1980, the new tentative
map was approved by the Planning Commission.
On July 9, 1980,
Wes Engineering prepared and executed a rough grading plan for
Tract No. 10018, which was approved by the city of Beaumont on
March 16, 1981.
In regard to the entire Beaumont Property in 1981, the city
of Beaumont required a bond of $365,000 to be posted to guarantee
construction of street improvements and sewer improvements.
In early 1981, the city of Beaumont contracted with CG
Engineering to design and prepare improvement plans for
Pennsylvania Avenue.
During 1981 and 1982, the city of Beaumont
- 7 built street improvements on Pennsylvania Avenue.
This
construction was funded by the city of Beaumont.
14 Lots Fronting Pennsylvania Avenue--Tract No. 10018-1
In 1981, petitioner subcontracted with Matich Corporation to
construct curbs, gutters, sidewalks, water service, waterline and
gate valves, and fire hydrants relating to the 14 lots along
Pennsylvania Avenue.
Petitioner paid $23,874.35 for this work.
In 1982, petitioner applied for a 1-year extension, which
was approved by the city of Beaumont, of its tentative map Tract
No. 10018.
In mid-1983, petitioner submitted a request to record
a final map for Tract No. 10018-1 to the city of Beaumont.
Tract
No. 10018-1 pertained to the portion (14 lots) of Beaumont
Property fronting Pennsylvania Avenue.
On September 20, 1983,
the Planning Commission conditionally approved petitioner's
phasing for Tract No. 10018-1.
On December 12, 1983, petitioner
and the city of Beaumont entered into an agreement for
subdivision improvements on Tract No. 10018-1.
The final map for
Tract No. 10018-1 was recorded on December 20, 1983, creating 14
lots along Pennsylvania Avenue.
In 1984, petitioner contracted with Michael C. Mize to
install 8-inch sewer laterals for the 14 lots along Pennsylvania
Avenue, at a total cost of $22,500.00.
On or about October 1986, petitioner contracted for the
construction of 14 single family residences in Tract No. 10018-1.
- 8 Petitioner entered into contracts with subcontractors, who built
the residences.
The 14 houses were constructed in two phases,
the first phase of 6 houses (construction commenced on October
17, 1986) and the second phase of 8 homes (construction commenced
on June 25, 1987).
Petitioner sold the 14 homes from July 21,
1987, through March 31, 1989, as follows:
Date of Sale
07/21/87
09/30/87
12/22/87
01/08/88
09/16/88
09/23/88
11/17/88
11/22/88
01/27/89
02/10/89
02/28/89
03/06/89
03/13/89
03/31/89
Address
1202 E. 10th Street
1050 Pennsylvania Avenue
1070 Pennsylvania Avenue
1090 Pennsylvania Avenue
1010 Pennsylvania Avenue
1110 Pennsylvania Avenue
1202 E. 11th Street
1201 E. 11th Street
1130 Pennsylvania Avenue
1120 Pennsylvania Avenue
1030 Pennsylvania Avenue
1100 Pennsylvania Avenue
1140 Pennsylvania Avenue
1150 Pennsylvania Avenue
Selling Price
$79,950
87,950
77,950
87,950
89,500
77,950
79,950
77,550
80,950
89,950
77,000
87,950
89,950
89,950
Petitioner classified the cost of the 14 houses on the Beaumont
Property under cost of houses sold, and classified income from
their sale as ordinary income.
Exchange Property--Tract No. 22332
The tentative map for Tract No. 10018 expired in 1983. In
regard to the remaining 48 lots of the Beaumont Property
(hereinafter referred to as the Exchange Property4) in Tract No.
10018, petitioner resubmitted a tentative map in March 1986.
4
Exchange Property is the Beaumont Property minus the 14
lots created by the final map of Tract No. 10018-1.
- 9 In March 1986, petitioner prepared a Parcel Map/Tract Map
Application Form and a City of Beaumont Environmental Review &
Processing Application Form for the Exchange Property.
During
May 1986, public hearings involving the Planning Commission
occurred in regard to the "proposed forty-eight (48) lot
subdivision for construction of single family homes."
On May 6, 1986, the city conditionally approved the
tentative map for the Exchange Property.
On June 9, 1986, the
city approved the tentative map for the Exchange Property, Tract
No. 22332, and subsequently extended the approval of the map
until June 9, 1989.
Garner, Troy & Associates prepared a draft tentative map,
dated July 1987, for Tract No. 22332.
Between January 1987 and
May 1989, Garner, Troy & Associates prepared the final map and
portions of the improvements plans for Tract No. 22332 in
accordance with the conditions, as revised, imposed by the city
of Beaumont.
At that time, petitioner worked with James Dotson, the
engineer for the city of Beaumont, to revise the conditions on
the Exchange Property.
For petitioner, Mr. Dotson was able to
lock-in the city's prices for its fees before the city
implemented Resolution No. 1988-10.
While petitioner never obtained a feasibility study of offsite improvements regarding the Exchange Property, Garner, Troy
- 10 and Associates prepared a Quantity and Cost Estimate
(Preliminary) for Tract No. 22332, dated January 16, 1987,
stating costs of $389,435.81 for the Exchange Property.
Later,
in a Quantity and Cost Estimate (Preliminary) for Tract No.
22332, dated February 3, 1988, Garner, Troy and Associates
estimated the costs were in the amount of $490,560.
The Quantity
and Cost Estimate was approved by Mr. Dotson for the city of
Beaumont on March 18, 1988.
On February 1, 1988, the city
approved a grading plan for Tract No. 22332.
Petitioner made no improvements on the Exchange Property.
Exchange
In 1988, Gold Coast Development, Inc. (Gold Coast),
approached petitioner with an offer of $650,000 to purchase the
Exchange Property.
Petitioner indicated that it was unwilling to
sell the Exchange Property, but would be willing to exchange the
Exchange Property.
On April 5, 1989, petitioner entered into an
exchange agreement with Empire Realty Exchange, Inc. (Empire).
The conveyance of the Exchange Property was contingent upon the
following:
(1) Petitioner's house plans being approved for construction
by the city of Beaumont;
(2) Gold Coast being able to secure building permits for the
houses;
(3) Gold Coast verifying with the city that all necessary
approvals to enable Gold Coast to record a final subdivision
map for 48 single family lots have been obtained;
- 11 (4) Securing 48 sewer permits for the project from existing
treatment plant's capacity; and
(5) Securing 48 water connections.
Pursuant to the exchange agreement, Empire agreed to acquire
and convey to petitioner one or more parcels of property to be
designated by petitioner.
On May 16, 1989, Empire arranged for
the sale of the Exchange Property to Ameriasian (successor in
interest to Gold Coast) for $674,000.
A grant deed conveying the
Exchange Property from petitioner to Ameriasian was recorded the
same day.
Petitioner did not receive any proceeds from the sale
of the Exchange Property.
Petitioner received a $584,800
exchange credit with Empire for acquiring property yet to be
designated.
Pursuant to the exchange agreement, petitioner designated
the following four properties to Empire, within 45 days after May
16, 1989:
(1) An undivided 7.87-percent interest in a parcel of
vacant land located along Phelan Road in Phelan, California; (2)
four lots with a house located along Mentone Boulevard in
Mentone, California; (3) three lots with a fast-food store
located along Mount Vernon in Colton, California; and (4) parcels
of vacant land located along Palm Avenue in Highland, California.
All four properties were commercial properties suitable for
constructing fast-food stores.
Empire purchased the four
designated properties within 180 days after May 16, 1989.
deeds conveying the four designated properties from the
Grant
- 12 respective sellers to petitioner were recorded within 180 days
after May 16, 1989.
Development of Exchange Property by Elkhorn
Around March/April 1989, Gold Coast approached Elkhorn
Development Company (Elkhorn) and proposed that they jointly
build 48 houses on the Exchange Property.
interested in a joint venture.
Elkhorn was not
Subsequently, Gold Coast offered
to sell the Exchange Property to Elkhorn.
In regard to the Exchange Property, Elkhorn discussed with
Robert Bounds, the city manager for Beaumont, topics such as the
water connections, sewer connections, the city conditions, and
the market. Elkhorn knew that the city had a limited number of
sewer permits. Elkhorn also discussed with Mr. Garner,
petitioner's engineer, the tentative map conditions and easements
on the Exchange Property.
Deciding it would be profitable to
purchase the Exchange Property, on April 13, 1989, Elkhorn agreed
to purchase the Exchange Property from Gold Coast/Amerasian.
On
May 16, 1989, Elkhorn purchased the Exchange Property from
Amerasian for $776,000.
In Resolution No. 1989-21, dated April 24, 1989, the city of
Beaumont authorized and consented to the filing of the Final Map
for Tract No. 22332.
On May 16, 1989, Elkhorn recorded the final
subdivision map for Tract No. 22332, creating 48 lots in the
- 13 Exchange Property.
The subdivision agreement for Tract No. 22332
was approved by the Beaumont City Council on February 13, 1990.
Around June/July 1989, Meadowlark Homes, a successor in
interest to Elkhorn, began to install the off-site improvements
for the Exchange Property.
Meadowlark Homes initially estimated
$480,000 ($10,000 per lot) as the cost for off-site improvements.
In a letter dated June 14, 1989, the Beaumont-Cherry Valley
Water District informed Meadowlark Homes of a proposed increase
in water connection fees, but gave Meadowlark Homes an
opportunity to obtain the connections at the existing rate.
On
June 20, 1989, Meadowlark Homes purchased the water connections
at the existing lower rate.
Around September/October 1989, Meadowlark Homes began
construction of the 48 houses.
Meadowlark Homes first built 24
houses, which were sold for an average price of $140,000.
Next,
Meadowlark Homes built the second set of 24 houses, but sales of
these houses were slower then the first 24 due to a drop in the
market at the end of 1990.
Ultimately, Meadowlark Homes made a
profit of about $630,000 on the sale of the 48 homes.
Tax Return and Accounting Information
Petitioner realized a $428,806 gain from the sale of the
Exchange Property.
This gain was reported on line 7 of Schedule
M-1 attached to petitioner's 1989 return.
Respondent in his
- 14 notice of deficiency dated July 13, 1995,5 determined that the
exchange did not qualify as a nontaxable exchange under section
1031(a).
Prior to the taxable year 1985, the accounting firm of
Sauer, Dudley, McKenzie and Bovee prepared petitioner's financial
statements and tax returns.
After taxable year 1985, the
accounting firm of Eadie and Payne prepared petitioner's
financial statements and tax returns.
From the time petitioner purchased the Beaumont Property
until the time petitioner disposed of the property in 1989,
petitioner classified the Exchange Property under work-inprogress accounts.
On its return for 1989, petitioner reported its business
activity as "RE SUBDIV & DEVELOP" and described the product or
service as "OPERATOR-DEVELOP."
OPINION
Generally a taxpayer must recognize the entire amount of
gain or loss on the sale or exchange of property.
Sec. 1001(c).
Section 1031(a)(1) provides an exception to the general rule and
allows a taxpayer to defer gain or loss from exchanges of
5
Petitioner signed Form 872, Consent to Extend Time to
Assess Tax, extending the time for assessment for the period
ended March 31, 1990, until December 31, 1995.
- 15 property held for productive use in a trade or business or for
investment.6
However, the nonrecognition treatment of section
1031(a) does not apply to any exchange of "property held
primarily for sale".
Sec. 1031(a)(2)(A).
The test of whether
property is held primarily for sale or for investment is applied
at the time of the exchange.
467, 487 (1987).
See Cottle v. Commissioner, 89 T.C.
Petitioner bears the burden of proving that it
had the requisite investment intent.
Click v. Commissioner, 78
T.C. 225, 231 (1982).
Respondent argues that the transaction fails to qualify
under section 1031 because petitioner held the Exchange Property
primarily for sale.7
Petitioner argues that it held the Exchange
Property for investment.
Consequently, our focus is solely upon
the characterization of the Exchange Property.
For purposes of section 1031, neither the Code nor the
regulations define "held for investment."
The regulations
provide that "[u]nproductive real estate held by one other than a
6
Sec. 1031(a)(1) provides:
In General--No gain or loss shall be recognized on the
exchange of property held for productive use in a trade or
business or for investment if such property is exchanged
solely for property of like kind which is to be held either
for productive use in a trade or business or for investment.
7
Respondent has not challenged the applicability of sec.
1031 on any other ground.
- 16 dealer for future use or future realization of the increment in
value is held for investment and not primarily for sale".
Sec. 1.1031(a)-1(b), Income Tax Regs.
In Bolker v. Commissioner,
760 F.2d 1039, 1045 (9th Cir. 1985), affg. 81 T.C. 782 (1983),
the court stated that "a taxpayer may satisfy the 'holding'
requirement by owning the property, and the 'for productive use
in trade or business or for investment' requirement by lack of
intent either to liquidate the investment or to use it for
personal pursuits."
For purposes of section 1031, neither the Code nor the
regulations define "held primarily for sale."
Whether property
is "held primarily for sale" is a question of fact.
In the
context of section 1221, the Supreme Court held that the term
"primarily" means "of first importance" or "principally."
Malat
v. Riddell, 383 U.S. 569, 572 (1966).
In analyzing "primarily for sale," petitioner relies on the
factors established in section 1221 cases, which are used to
determine whether property was primarily held for sale to
customers in the ordinary course of business:
(1)
(2)
(3)
(4)
(5)
(6)
The purpose for which the property was initially
acquired;
the purpose for which the property was subsequently
held;
the extent to which improvements, if any were made
to the property by the taxpayer;
the frequency, number, and continuity of sales;
the extent and nature of the transactions involved;
the ordinary business of the taxpayer;
- 17 (7)
(8)
(9)
the extent of advertising, promotion, or other active
efforts used in soliciting buyers for the sale of the
property;
the listing of property with brokers; and
the purpose for which the property was held at the time
of sale.
Maddux Constr. Co. v. Commissioner, 54 T.C. 1278, 1284 (1970).
None of the factors are conclusive standing alone, but rather all
of the factors taken as a whole govern.
Id.
Respondent correctly points out that section 1221 applies a
different standard than section 1031.
35 T.C. 90, 96 (1960).
See Black v. Commissioner,
Section 1221(1) excludes from the term
"capital asset" property "held by the taxpayer primarily for sale
to customers in the ordinary course of his trade or business".
(Emphasis added).
Unlike section 1221, the qualifying language
of section 1031 omits the phrase "to customers in the ordinary
course of his trade or business".
Because section 1031(a)(2)(A)
deals only with property "held primarily for sale," this is the
only requirement for the applicability of the exception to
section 1031.
Id.; see Woodbury v. Commissioner, 49 T.C. 180,
197 (1967); Land Dynamics v. Commissioner, T.C. Memo. 1978-259.
In determining whether the Exchange Property was "held
primarily for sale," the factors presented in section 1221 cases,
such as Maddux Constr. Co. v. Commissioner, provide guidance in
making this determination, but we are not concerned with factors
analyzing whether the property was sold "to customers in the
ordinary course of * * * business" or whether the property was
- 18 held in petitioner's "trade or business."
See Black v.
Commissioner, supra at 96 (Court rejected taxpayer's argument
that property acquired in a like-kind exchange but held primarily
for sale should come within section 1031 if the sale was not
within the taxpayer's ordinary course of business); Paullus v.
Commissioner, T.C. Memo. 1996-419.
As a result, the exclusion of
"property held primarily for sale" from nonrecognition treatment
in section 1031(a)(1) is broader than the exception to capital
gain treatment in section 1221(1).
Purpose For Which Beaumont Property Was Initially Acquired
Petitioner argues that its original intent in purchasing the
Beaumont Property was to construct duplex or four-plex rental
apartment units.
According to petitioner, its intent was to hold
such units for long-term investment.
Petitioner relies on Mr.
Baker's testimony regarding discussions with his broker Carl
Mellor about rezoning the property to multi-family use.
We do not find Mr. Baker's statements regarding petitioner's
original intent persuasive.
In direct contrast with the
assertion that petitioner intended to hold the property for
construction of duplex or four-plex rental units, its purchase
was contingent upon the tentative subdivision map for the
Beaumont Property being approved by the city of Beaumont.
This
tentative map proposed to subdivide the property into 48 lots for
- 19 the construction of single-family residential houses.8
Petitioner did not make the purchase contingent on getting R-4
multi-family residential zoning.
Further, when petitioner purchased the Beaumont Property on
March 10, 1978, the property was zoned R-1 for single-family
residential homes.
Afterwards, petitioner never made any
attempts to have the Beaumont Property rezoned to multi-family
residential use.
The Beaumont Property was not suitable for
commercial development (such as a fast-food location).
From the evidence, we find that petitioner's initial purpose
in acquiring the Beaumont Property was to hold the property for
sale (subdivide the property into lots for single-family
residential houses).
Intent After Acquisition
"[W]hile the purpose for the acquisition must be given
consideration, intent is subject to change, and the determining
factor is the purpose for which the property is held at the time
of" the exchange.
Eline Realty Co. v. Commissioner, 35 T.C. 1, 5
(1960); see Cottle v. Commissioner, 89 T.C. at 487.
Thus, we
must decide whether petitioner abandoned its original intent and
8
At trial, Mr. Baker testified that the lot sizes and
configurations of the tentative map would be suitable for the
construction of duplexes. However, the tentative map
specifically proposed single-family residential houses.
- 20 thereafter at the time of the exchange held the property for
investment.
In an attempt to show its later intent, petitioner points
out that only after purchasing the Beaumont Property did its
broker Mr. Mellor inform petitioner that it would not be able to
get the Beaumont Property rezoned.
It is argued that at this
point petitioner decided not to subdivide the Beaumont Property,
but instead, decided merely to process a tentative map to
determine conditions for development of the property.
After
determining the conditions, petitioner would be able to analyze
the costs and feasibility of development.
According to petitioner, after obtaining approval of the
1980 tentative map (which contained conditions for development of
the property), it was decided that development of the Beaumont
Property was not feasible because the cost of off-site
improvements was too high for the construction of entry-level
homes.
Petitioner asserts at this point it held "the property
without any specific plan of action."
Other evidence indicates that petitioner had an intent to
subdivide the property (such as the discussion with C.H. J.
Materials Laboratory, Inc., regarding a soil investigation
report).
On April 23, 1979, petitioner's Board of Directors
authorized the preparation and filing of an application to the
Real Estate Commissioner of the State of California for a Public
- 21 Report in connection with the subdivision and sale of real
property on the 48 lots of the Beaumont Property.
This
reinforces the conclusion that as of April 23, 1979, the Board of
Directors decided to subdivide the Beaumont Property.
Also, Mr.
Baker testified that he felt that petitioner would go ahead and
try to subdivide it into single family houses, which resulted in
a series of changes in the tentative map over a period of several
years.
Subsequent Intent in Regard to the 14 Lots vs. the 48 Lots
Contemporaneous facts, not self-serving testimony given
years later, are important in establishing intent.
Philhall
Corp. v. United States, 546 F.2d 210, 215 (6th Cir. 1976);
Raymond v. United States, 511 F.2d 185, 190 (6th Cir. 1975).
In
establishing its intent, petitioner relies heavily on Mr. Baker's
statements.
In evaluating these statements, we examine them in
light of the events that transpired from 1978 until the exchange
in 1989.
In particular, we examine petitioner's development of the 14
lots in Tract No. 10018-1 and petitioner's actions in regard to
the Exchange Property because intent may vary from tract to
tract.
See Mathews v. Commissioner, 317 F.2d 360, 361 (6th Cir.
1963).
Based on the city of Beaumont's construction of improvements
along Pennsylvania Avenue in 1981 and 1982, petitioner asserts
- 22 that it changed its intent with respect only to the 14 lots
fronting Pennsylvania Avenue.
It contends that Mr. Baker made a
determination that the 14 lots could be inexpensively subdivided
and that entry-level houses could be profitably built on Tract
No. 10018-1.
From that time forward, petitioner's intent was to
hold the 14 lots for sale.
After obtaining the final map for
Tract No. 10018-1, petitioner ultimately subdivided the 14 lots,
constructed the 14 houses, and sold the 14 houses.
Petitioner asserts that its intent in regard to Tract No.
10018-1, held for sale, differed from its intent in regard to the
Exchange Property.
Mr. Baker testified that at the time of the
filing of the final map for the 14 lots fronting Pennsylvania
Avenue, he had already decided that constructing homes on the
remaining portion of the property was not feasible.
Petitioner
contends that it partitioned the 48 lots constituting the
Exchange Property from the rest of the tract, as evidenced by the
recording of the final map relating only to the 14 Lots and
excluding the Exchange Property.9
9
The fact that the final map only pertained to the 14 lots
fronting Pennsylvania Avenue does not lead to the conclusion that
the Exchange Property was held for investment. It is possible
that petitioner partitioned the property for other reasons, such
as minimizing the bond to be posted for improvements on the
property.
We note that a letter, dated Sept. 28, 1983, written by
Garner, Troy & Associates, Inc., and signed by Mr. Baker, implied
that petitioner would undertake in stages the development of the
entire tract:
(continued...)
- 23 Petitioner primarily relies on Mr. Baker's statements to
determine its intent at the time of the exchange.
In support of
its intent not to subdivide the Exchange Property, petitioner
lists several factors:
(1) Cost of off-site improvements,
(2) lack of housing market, (3) other obstacles, and (4) health
concerns.
According to petitioner, the primary reasons for not
subdividing the Exchange Property were the cost of the off-site
improvements and its unsuccessful sales record in selling the 14
lots in Tract No. 10018-1.
(1) Feasibility of Development (Off-Site Costs)
Petitioner claims that the cost of off-site improvements
prohibited development of the 48 lots in the Exchange Property.
As a result, petitioner argues that it held the Exchange Property
for investment.
In regard to the Exchange Property, petitioner
received an estimate of off-site costs in 1987 in the amount of
$389,435.81, and received another estimate in 1988 in the amount
9
(...continued)
On behalf of our client Neal T. Baker Enterprises Inc. owner
of approved Tentative Tract No. 10018 we hereby request
permission to phase Tract 10018. Our client wishes to
initially improve and build on lots adjacent to Pennsylvania
Avenue (Lots 1-14 as shown on the attached print of a copy
of the approved Tentative map from Tract 10018).
Although it is the owner's intent to phase this Tract
into two phases, defining the initial Tract by number 100181; subsequent phases, if any, would be defined as Tract No.
10018-2, Tract No. 10018-3 etc., with the number 10018
defining the last phase. Improvement plans, street, sewer,
water grading etc. shall be modified to correspond and made
compatible for any and all phases to the satisfaction of the
city of Beaumont.
- 24 of $490,560.
Petitioner compares these estimates to the off-site
costs incurred in regard to the 14 lots of approximately $5,000
per lot.
In regard to the off-site improvements, respondent submitted
an expert report, prepared by Donald Lohr, which estimated the
off-site improvement costs for the Beaumont Property.
Mr. Lohr
estimated off-site improvements for the 14 lots in Tract No.
10018-1 to be $5,821.82 per lot.
Using the 1987 cost estimate,
to which he then added costs of waterlines and appurtenances plus
costs for miscellaneous items, Mr. Lohr initially determined the
off-site cost in 1987 was $10,767.74 per lot for the Exchange
Property (the 1989 cost would be $11,198.45).
In light of
information available after filing his report (the 1988 cost
estimate), Mr. Lohr determined that the off-site costs were
slightly over $12,000 per lot for the Exchange Property.
Mr. Lohr stated that these costs associated with Tract No. 100181 and Tract No. 22332 were not prohibitive.
According to Mr.
Lohr, "[t]he [costs] to develop Tract No. 10018-1 were below the
average cost to develop single-family lots at that time and the
[costs] to develop Tract No. 22332 were no more than average" in
relation to those prevailing in 1989.
According to Mr. Kanengiser of Meadowlark Homes, the
off-site costs incurred by Meadowlark Homes in developing the
Exchange Property were not cost prohibitive.
Meadowlark Homes
- 25 estimated the off-site improvement costs to be $10,000 per lot.
In its development of the Exchange Property, Meadowlark Homes did
not encounter any unusual or exorbitant off-site improvement
costs, sewer permit costs, water connection costs or other costs
related to the construction of the 48 houses.
Petitioner points out several weaknesses to Mr. Lohr's
report.
One weakness is that Mr. Lohr's report included only an
estimate for off-site improvements.10
Because Mr. Lohr's report
was not a full feasibility study, the report excluded
consideration of such items as land costs, financing costs, and
overhead costs.
However, prior to filing its post-trial briefs,
petitioner did not draw attention to those items and argued only
that the off-site costs made development of the Exchange Property
infeasible.
Even if petitioner may now extend its position, it
offered no evidence of the breakdown of the total costs (other
than the off-site costs) to show that total costs presented an
impediment to developing the Exchange Property.
As noted,
petitioner never obtained a feasibility study in regard to the
property.
Petitioner also points out that Mr. Lohr's estimate of the
off-site costs for each of the 48 lots was roughly double his
estimate of the off-site costs associated with each of the 14
10
Off-site improvements include such things as grading,
utilities, electricity, sewer, water, and cable.
- 26 lots.
Mr. Lohr noted that an estimate of the costs for 14 lots
in 1989 would have been $6,642.41 per lot.
Petitioner compares
this to the roughly $12,000 per lot for the 48 Lots in the
Exchange Property.
According to petitioner, the estimated profit
per home of about $8,000 per lot would be wiped out by the
increased off-site cost of $6,000 per lot.
Our evaluation of petitioner's argument is restricted
because it did not submit any projected profit analysis for the
development (besides Mr. Baker's testimony).
In regard to the 14
lots, only after construction did Mr. Baker check the costs and
he felt there was a profit somewhere around "4- to 5-, $6,000 per
house, maybe a little higher."
Later, Mr. Baker testified that
petitioner made profit of around $8,000, maybe $8,000 to $10,000.
The parties submitted a summary by petitioner's accountant
Eadie and Payne reflecting the following income on the sale of
the 14 houses:
Date of Sale
07/21/87
09/30/87
12/22/87
01/08/88
09/16/88
09/23/88
11/17/88
11/22/88
01/27/89
02/10/89
02/28/89
03/06/89
03/13/89
03/31/89
Address
1202 E. 10th Street
1050 Pennsylvania Avenue
1070 Pennsylvania Avenue
1090 Pennsylvania Avenue
1010 Pennsylvania Avenue
1110 Pennsylvania Avenue
1202 E. 11th Street
1201 E. 11th Street
1130 Pennsylvania Avenue
1120 Pennsylvania Avenue
1030 Pennsylvania Avenue
1100 Pennsylvania Avenue
1140 Pennsylvania Avenue
1150 Pennsylvania Avenue
Selling Price
$79,950
87,950
77,950
87,950
89,500
77,950
79,950
77,550
80,950
89,950
77,000
87,950
89,950
89,950
Income
$17,812.74
21,312.48
13,469.04
25,859.29
23,297.54
12,891.26
13,133.62
13,502.00
13,403.44
22,556.98
2,875.26
20,469.47
23,236.19
22,667.19
- 27 According to this, petitioner's income from the sale of the
houses averaged $17,606.18.
Petitioner attempts to reduce the profit from the sale of
the 14 houses by pointing out that the following costs were not
allocated to its construction activities:11
(i) the cost of
overhead and supervision; and (ii) the interest costs associated
with the use of corporation capital to construct the homes.
Mr. Baker considered these costs in determining profit from
construction activities.
However, Mr. Baker testified that he did not know the costs
until petitioner's accountant Eadie and Payne informed him.
Further, Mr. Baker testified that he did not know how the
accountants accounted for the cost of overhead and supervision.
Petitioner did not call its accountants to clarify or explain any
of petitioner's cost and profit analysis.
See Wichita Terminal
Elevator Co. v. Commissioner, 6 T.C. 1158, 1165 (1946) (drawing
negative inference if evidence is within possession yet it is not
introduced), affd. 162 F.2d 513 (10th Cir. 1947).
Petitioner
also did not incur significant interest costs because it
generally used cash on hand, avoiding construction financing.
While petitioner criticizes Mr. Lohr for not preparing a pro
forma budget for the project, it provided no evidence to
11
Respondent suggested a profit of $17,606.18 per house,
while petitioner asks the court to accept an average net profit
of approximately $7,000 to 10,000 per home.
- 28 establish petitioner's projected budget for costs or its
estimated profit (or loss).
Additionally, petitioner argues that
Mr. Lohr's statement that the costs for the 48 lots were "no more
than average" does not change the fact that Mr. Baker believed
that the cost per lot was too expensive for building entry-level
homes.
However, petitioner provided no evidence to support Mr.
Baker's statements.
Petitioner acknowledges this:12
"The only
testimony before the court is the testimony of Baker who
testified that he concluded that it would not be profitable to
do so."
We are reluctant to accept Mr. Baker's conclusion.
We find that the off-site costs for the Exchange Property
were not prohibitive in regard to petitioner's development of the
Exchange Property.
12
Mr. Garner, petitioner's engineer, mentioned a
conversation with Mr. Baker: "I don't know whether he used the
word 'horrendous,' but he used some terminology saying the this
was far, far more than the other 14 lots would cost him, and he
was discouraged at this amount." Petitioner uses the statement
to support its position that the costs were exorbitant, but the
statement merely shows what Mr. Baker told Mr. Garner about the
costs.
- 29 (2) Housing Market and Sales
Petitioner also asserts that another factor in petitioner's
determination not to develop the 48 lots was the unsuccessful
sales program for the 14 lots in Tract No. 10018-1.
In light of
the slow sales, petitioner concluded that a market for entrylevel homes in Beaumont did not exist.
On or about October 1986, petitioner contracted for the
construction of 14 single family residences in Tract No. 10018-1.
The 14 houses were constructed in two phases, the first phase
consisting of 6 houses (construction commenced on October 17,
1986) and the second phase consisting of 8 homes (construction
commenced on June 25, 1987).
Mr. Baker testified that the sales of the first six homes
were slow, at a rate lower than anticipated or acceptable to
petitioner.
Mr. Baker remarked that petitioner held the
completed homes for an average for 9 months.
The second phase
sold quicker, but sales were still unacceptable to petitioner.
Mr. Baker felt that it was not worth further subdividing the
property due to the slow sales, the amount of money expended, and
the trouble of building the 14 houses.
In regard to the holding period, petitioner relies on the
fact that the 14 houses sold from July 21, 1987, to March 31,
1989, which is approximately a 20-month span.
Additionally,
petitioner points out that only three houses sold during 1987 and
- 30 that the house located at 1030 Pennsylvania Avenue took
approximately 19 months to sell.
However, petitioner's arguments oversimplify the facts.
In
determining the holding period, we need to know when the houses
were completed and compare this to the sales dates.
Examining
the record, we find the final inspection date of each of the 14
houses.
Mr. Baker stated that each house was completed (except
for the appliances, fixture, carpets) and ready for sale prior to
the final inspection date.
Due to problems in the area
(vandalism, etc.), in some instances the final inspection did not
occur until shortly before the house was sold.
But petitioner
presented no evidence to show when the houses were substantially
completed.
The final inspection date and the sale date for each house
are as follows:
Final Inspection Date
Date of Sale
07/10/87
07/23/87
07/23/87
07/23/87
07/23/87
08/23/88
08/23/88
10/31/88
01/23/89
02/06/89
07/23/87
10/21/88
02/23/89
02/27/89
07/21/87
09/30/87
12/22/87
01/08/88
09/16/88
09/23/88
11/17/88
11/22/88
01/27/89
02/10/89
02/28/89
03/06/89
03/13/89
03/31/89
Address
1202 E. 10th Street
1050 Pennsylvania Avenue
1070 Pennsylvania Avenue
1090 Pennsylvania Avenue
1010 Pennsylvania Avenue
1110 Pennsylvania Avenue
1202 E. 11th Street
1201 E. 11th Street
1130 Pennsylvania Avenue
1120 Pennsylvania Avenue
1030 Pennsylvania Avenue
1100 Pennsylvania Avenue
1140 Pennsylvania Avenue
1150 Pennsylvania Avenue
Phase
1
1
1
1
1
2
2
2
2
2
1
2
2
2
- 31 According to petitioner's records, the house at 1030 Pennsylvania
Avenue in Phase 1 (which was completed on or before 7/23/87 and
sold 2/28/89) was the model home; so the long holding period for
this house is not significant.
Treating the final inspection
date as the date of completion and the sale date and excluding
the sale of the model home, petitioner held the houses in Phase 1
for about 5.3 months apiece and held the houses in Phase 2 for
about 1.3 months apiece.
In light of the evidence, we are not
persuaded by Mr. Baker's testimony that sales of the 14 houses
were unacceptably slow.
Meadowlark Homes' Success with the Exchange Property
Respondent uses Howard Kanengiser's (of Meadowlark Homes)
testimony to establish the market for the development of the
Exchange Property.
Meadowlark Homes experienced brisk sales in
1989 in regard to the first 24 homes.
In 1990, due to the
recession, Meadowlark Homes experienced a drop off in sales in
regard to the second 24 homes.
Meadowlark Homes made
approximately $630,000 in profit on the development.
This was
approximately one-third less than Meadowlark had anticipated.
In regard to Meadowlark's slower sales for the second phase,
petitioner argues that this supports its position that it held
the Exchange Property for investment because Mr. Baker foresaw
the poor sale of homes in Beaumont based on (i) the poor sales
record on the first 14 homes, (ii) the fact that Beaumont is a
- 32 low-income area that failed to share in the Southern California
housing boom, and (iii) his experience in the banking business.
However, Mr. Kanengiser's testimony indicated that the recession
was unforeseeable.
In discounting the relevance of Mr. Kanengiser's testimony,
petitioner points out the difference between Meadowlark Homes'
development and petitioner's development:
(1)
(2)
Meadowlark Homes built houses with an average selling
price of $140,000 while petitioner built "entry level
housing" in the $70,000 to $100,000 range; and
Meadowlark Homes borrowed approximately $6,000,000 to
finance the project while petitioner used working
capital, borrowing no more than $400,000.
Mr. Baker testified that petitioner was not equipped for more
than entry-level houses.
We know that petitioner's 14 houses in Tract No. 10018-1
sold in the price range of $77,000 to $89,950 and that Meadowlark
Homes upgraded petitioner's plan selling its houses for about
$140,000.
At trial, there was testimony presented regarding the
market in the city of Beaumont.
Mr. Dotson, the city's engineer,
and Mr. Bounds, the city's manager, testified to the increased
real estate market in Beaumont from 1985 until the recession in
1990.
Other than Mr. Baker's testimony, petitioner presented no
market data on sales in Beaumont.
Mr. Baker admitted he was
generally unaware of the general level of income in Beaumont and
had merely an impression of the market.
We are not convinced
that the market in Beaumont supported only the upgraded houses of
- 33 Meadowlark Homes and did not support petitioner's type of
development as well.
Further, there was no evidence presented to establish that
petitioner was equipped only for entry-level houses.
In regard to petitioner's second point, petitioner did not
establish that its borrowing policy limited the type of house
built and the number of houses built.13
From the record, we find that a market for single-family
residential homes existed at the time of the exchange in 1989.
Petitioner has not persuaded us that the market did not support
its development of "entry-level low income houses."
(3) Other Obstacles
Petitioner also asserts that other obstacles arose in
connection with subdividing the 48 lots, which led to Mr. Baker's
conclusion that development of the Exchange Property would not be
profitable.
First, petitioner points to the fact that Beaumont-Cherry
Valley Water District was increasing its water connection fee by
approximately $450 per lot.
However, in June 1989, Meadowlark
Homes was able to purchase the water connection at the existing
rate (prior to the increase).
13
Mr. Baker testified that the maximum loan obtained by
petitioner was $400,000. However, petitioner authorized its
officers to obtain construction financing. For example, in the
taxable year 1989, petitioner had a $700,000 construction line of
credit which expired in Feb. 6, 1991.
- 34 Next, petitioner points to communications by the city of
Beaumont of a possible limitation in sewer permits.14
Sewer
permits play a necessary role because in order to begin
construction, building permits and sewer permits are both
required.
We note that there was concern about the city's sewer
capacity in 1988.
The city began to investigate the building of
a new sewer plant.
While the city manager Mr. Bounds was the
only person who knew the number of available permits, there was
no evidence presented regarding any discussion of sewer permits
between petitioner and him.
Meadowlark Homes was able to acquire
sewer permits for the 48 lots in the Exchange Property.
Further,
as of 1993, the city of Beaumont had not run out of sewer
permits.
In light of the above, we find that availability of
sewer permits was not an obstacle to petitioner's development of
the Exchange Property.15
(4) Health Concerns
At trial, petitioner introduced evidence of Mr. Baker's
health.
In November 1988, he was diagnosed with cancer. He had a
14
However, Mr. Baker testified that he decided not to
subdivide the Exchange Property before learning about the
potential of a moratorium.
15
In its reply brief, petitioner attempts to show that Mr.
Baker's decision to not record the final map in light of the
threat of a moratorium shows that it was petitioner's intent to
not develop the Exchange Property. However, we find little
significance to petitioner's characterization in light of the
lack of evidence regarding the threat.
- 35 fifty-fifty chance of survival.
In November 1988, Mr. Baker
underwent surgery, which was followed by chemotherapy.
Mr. Baker
testified that as a result of contracting cancer, he made a
decision that petitioner would discontinue subdividing land;
thereafter, petitioner built some homes on existing lots but no
longer subdivided raw land into lots.
As petitioner's main decision maker, Mr. Baker's health
impacts petitioner, but we are examining petitioner's intentions
in regard to the Exchange Property in 1989 and not necessarily
petitioner's decisions regarding other aspects of its trade or
business.
We first consider Mr. Baker's statement that he spent only
20 percent of his time at the time of exchange working for
petitioner, while he spent the other 80 percent of his time
supervising the food operations of Baker's Burgers, Inc.
Mr.
Baker and Terry Talley managed petitioner's construction
activities.
Because petitioner subcontracted all of its
construction work, the actual number of permanent employees
employed by petitioner or Mr. Baker's diminished time with
petitioner is of little significance.
Petitioner presented no evidence of actions of its Board of
Directors to corroborate Mr. Baker's statement that petitioner no
longer was subdividing land.
Instead, we note that on Form 1120,
for the taxable years 1988, 1989, 1990, and 1991, petitioner
- 36 listed "subdivider and developer" instead of "real estate
operator and lessor of building" as its principal business
activity.
Additionally, the evidence shows that petitioner continued
its subdividing and developing activities.
For example,
petitioner continued to build houses on the 20-lot tract in
Yucaipa after petitioner allegedly discontinued developing,
recording the income from the sale of the houses as ordinary
income in 1990, 1991, 1992, and 1993.
In regard to these other
developments by petitioner, we know that it continued to hold
these properties for sale, rather than investment.
The record
does not substantiate petitioner's assertion that it built homes
on existing lots and no longer subdivided raw land into lots.
Mr. Baker's mere statements that petitioner intended to
discontinue the development business are not enough to change the
characterization of the Exchange Property.
See Tollis v.
Commissioner, T.C. Memo. 1993-63, affd. per curiam without
published opinion 46 F.3d 1132 (6th Cir. 1995).
Petitioner
presented no objective and contemporaneous evidence to establish
its change in intent.
Considering petitioner's actions, Mr.
Baker's health concerns do not persuade us to accept petitioner's
conclusion that it stopped its subdividing and developing
activities.
- 37 Other Evidence--Petitioner's Actions
While petitioner's intent at the time of the exchange is
critical, it primarily relies on Mr. Baker's statement to
establish its intent, without examining the actions of petitioner
as a corporation.
See Raymond v. United States, 511 F.2d 185,
190 (6th Cir. 1975).
Ordinary Business
Several courts have considered whether a taxpayer's real
estate operations were limited to the properties in question or
were engaged in as part of a general real estate business.
Eline
Realty Co. v. Commissioner, 35 T.C. at 5 (discussing this point
in the context of a predecessor of section 1221); Maddux Constr.
Co. v. Commissioner, 54 T.C. at 1284.
We recognize that a
taxpayer in the real estate business may also acquire and hold
real property for investment purposes.
Maddux Constr. Co. v.
Commissioner, supra at 1286 (dealing with section 1221).
The
taxpayer has the burden of proving that when dealing with the
property it was wearing the hat of an investor rather than that
of a dealer.
Pritchett v. Commissioner, 63 T.C. 149, 164 (1974).
In determining this, we accord greater weight to the objective
facts than to petitioner's statements regarding investment
intent.
Further, "a subsequent sale is not conclusive on the
question of the primary purpose in acquiring and holding the real
- 38 estate."
Municipal Bond Corp. v. Commissioner, 382 F.2d 184, 188
(8th Cir. 1967), revg. in part and affg. in part 46 T.C. 219
(1966) (dealing with section 1221).
The fact that land was held
for many years does not, by itself, establish an intention to
hold the property for investment rather than sale.
See Stockton
Harbor Indus. Co. v. Commissioner, 216 F.2d 638, 655-656 (9th
Cir. 1954).
In claiming that it held the Beaumont Property and the
Exchange Property for investment purpose, petitioner asserts that
its subdividing and developing activities were very limited.16
Petitioner points out that it sold all of its houses through
unrelated realtors and that it did not engage in any construction
activities, instead it used subcontractors.
Petitioner contends
that the heart and soul of petitioner related to the location,
development, and construction of fast food sites to be held for
investment.
Petitioner states that a majority of its income is
derived from the rental of fast-food locations17 (Mr. Baker
16
Petitioner also asserts that it had a history of holding
properties for investment, including properties that it at one
time intended to develop. However, the record does not support
petitioner's position.
17
At times, petitioner blurs the distinction between
petitioner and the separate corporation Baker Burger's Inc. When
petitioner spun off in 1969 the fast-food operations to Baker
Burger's Inc., Mr. Baker stated that the two businesses were for
all practical purposes totally unrelated, and that it had become
necessary to conduct the two businesses separately in order to
facilitate flexibility, expansion, cost control, proper
(continued...)
- 39 having been one of the originators of the fast-food concept in
the United States) and other rental properties.
The tax returns provide the following:
1984
1985
1986
1987
1988
1989
Gross Receipts
$184,528
Cost of Goods Sold
(cost-houses & lots) 116,899
Gross Profits
67,629
$410,000
$927,000
$1,684,469
$1,253,850
$1,210,350
283,171
126,829
691,058
235,942
1,507,664
176,805
1,070,108
183,742
1,082,998
127,352
Gross Rents
613,758
688,147
733,308
841,314
1,413,983
1,834,533
Net Capital Gain
58,536
694,880
16,774
18,545
20,351
-0-
Ordinary Gain
6,308
-0-
-0-
-0-
-0-
-0-
Petitioner points out that the financial records divide its
operations into rental activities and construction activities.
It argues that its profits from construction activities range
from 6.5 percent to 24.3 percent, indicating a trend of decreased
profits from construction activities and of increased profits
from rental activities over the period.
In making this argument,
petitioner compared gross profits from construction activities to
gross rents.
Presented with only petitioner's financial returns,
we cannot accept its conclusion that construction of property
held for sale was a minor portion of its activities, when
petitioner had gross receipts of $1,253,850 in 1988 and
$1,210,350 in 1989, compared to gross rents of $1,413,983 in 1988
and $1,834,533 in 1989.
17
(...continued)
management and the raising of capital.
- 40 Furthermore, for each taxable year 1982 through 1991, on
Form 1120, petitioner listed "real estate subdivider and
developer" as its principal business activity.18
While "real
estate operator and lessor of buildings" is an option provided in
the Instructions to Form 1120, during 1981 to 1991, petitioner
never listed "real estate operator and lessor of buildings" as
its principal business activity.
In taxable year 1987, on Form 3115, petitioner stated that
its business and principal income was "real estate subdivider and
developer, real estate rentals," and affirmatively answered that
it produced or acquired property for resale to which section 263A
applied.
Mr. Baker testified that petitioner was in the business of
subdividing and developing prior to 1990.
However, petitioner
asserts that this is true only to the extent that the subdivision
and development activities related to the eventual construction
of fast-food stores or, in some circumstances, single-family
residences.
Mr. Baker stated that of the 80 fast-food locations
owned by petitioner, it built approximately 50 of them.
While
his testimony is unclear and undocumented, it seems that
18
Even though petitioner listed the wrong code number for
real estate subdivider and developer from 1982 through 1991,
petitioner specifically stated its business as real estate
subdivider and developer.
- 41 petitioner constructed the 50 locations over a period from prior
to its incorporation in 1957 to the date of the trial.
Besides
Mr. Baker's statement of constructing fast-food locations,
petitioner did not present any evidence regarding subdivision
activities on property on which fast-food stores were later
constructed.
On the other hand, we note that petitioner was engaged in
developing other properties (in addition to the Beaumont
Property) from 1978 to 1991.
Petitioner purchased 75 unimproved
lots in Pacific Street in Highland, California.
Petitioner built
25 houses, installed improvements on the remaining 50 lots, and
sold all the lots in 1980.
Petitioner also had development
projects in San Bernardino, Yucaipa (20 lots, which were
purchased in 1986 for the purpose of building houses thereon and
to sell the houses upon completion), and La Quinata (20 lots,
which were purchased in 1988).
We agree with petitioner that it was engaged in several
activities, which included acquiring and holding real estate for
fast-food locations (which were later leased to Baker's
Burgers).19
19
At the same time, we find that petitioner also was
Petitioner states that:
Its activities included the following (i) holding raw land
for investment purposes, (ii) holding fee title to fast-food
locations for rental to Baker's Burgers, (iii) acting as
master lessor to Baker's Burgers with respect to fast-food
(continued...)
- 42 engaged in the business of subdividing and developing before and
during the taxable year 1989.20
We note that section 1031 use of
"held primarily for sale" does not require that the property be
sold in the ordinary course of petitioner's trade or business (as
provided in section 1221(1)).
Books and Records
Courts have used a taxpayer's books and records as evidence
of an intent to change the character of an asset.
As of March 1979, petitioner classified the Beaumont
Property in Account No. 1160 for finished houses and work-in-
19
(...continued)
locations which were leased from third parties, (iv)
developing new fast-food sites for Baker's Burgers and
leasing those new sites to Baker's, (v) leasing fast-food
sites to third parties, and (vi) constructing homes for
sale.
20
Respondent asserts that a real estate "subdivider" is
one that obtains land, goes through the process of filing a final
map to subdivide property into lots, and sells the lots. And
that a real estate "developer" is one that obtains the lots,
installs the improvements on the lots, builds houses on the lots,
and sells the houses.
Petitioner contends that respondent's analysis of the term
"subdivider" and "developer" is inaccurate. Petitioner states
that: "With respect to the homes built by Enterprises, it was
its practice to either purchase subdivided land or to both
subdivide land and construct homes on the subdivided lots."
Mr. Dotson testified that there is potential for overlap in
the terms "subdivider" and "developer."
We need not worry about the exact definition of subdivider
and developer because we find that petitioner was engaged in the
business of both, depending on the development. To the extent
properties were subdivided, petitioner intended to build
improvements on these properties. Further, while petitioner
contends it no longer subdivided raw land into lots after 1988,
the record does not support this contention.
- 43 progress, with the following description "Beaumont Subdivision
(Tract 10018) 46 unimproved lots."
In regard to the 14 lots in
Tract No. 10018-1, the lots were recorded in work-inprogress/construction-in-progress account and finished houses
account.
Petitioner never moved the property from these
accounts.
Petitioner also listed the Exchange Property, Tract
No. 22332, under the category of work-in-progress/constructionin-progress (Account No. 1160), and never moved the Exchange
Property from that account during the period of 1978 to 1989.
Petitioner asserts that the characterization of the Exchange
Property as work-in-progress was made by its accountants without
Mr. Baker's knowledge.
Mr. Baker claims that the accountants
incorrectly classified properties under work-in-progress
accounts.
Petitioner points out that many properties that were
clearly held for investment (such as fast-food stores) were
listed under the work-in-progress category.
It attempts to
categorize the work-in-progress category as a suspense account
used to keep track of expenses.
Petitioner concludes that the
Exchange Property was listed under the work-in-progress account
because the petitioner made expenditures for engineering costs
associated with the property.
In its assertions that properties were listed
inconsistently, petitioner solely relies on Mr. Baker's
statements about its use of the properties and the
- 44 misclassification of its properties.
Even though petitioner's
accountants were listed as witnesses in the pretrial memorandum,
it never called the accountants to explain, verify, or discuss
why properties were recorded in a certain manner.
See Wichita
Terminal Elevator Co. v. Commissioner, 6 T.C. at 1165.
Further,
petitioner did not provide any other evidence to explain its
manner of accounting for the properties.
We note that petitioner's characterization of the Exchange
Property in its records is consistent with its treatment of the
Pacific Street Subdivision in Highland, California.
In regard to
75 lots in the Pacific Street Subdivision, petitioner built 25
houses, and installed only improvements on the remaining 50 lots.
However, petitioner kept all 75 lots in the work-in-progress
account until they were sold in 1980.
Petitioner classified
income from the sale of the houses and the unimproved lots as
ordinary income.
Petitioner also listed its residential
development in Yucaipa under work-in-progress account No. 116081, and its residential development in La Quinata under work-inprogress account No. 1160-85.
This is compared to petitioner's treatment of the Leedom
Tract, 41 unimproved lots.
While Leedom was initially in 1978
classified in the work-in-progress account, petitioner later in
1985 reclassified the property into the "unimproved land and
vacant lots" account No. 1280-31.
In regard to the Exchange
Property, which was unimproved land, petitioner never moved the
- 45 property from the work-in-progress account into the unimproved
land and vacant lot account.
In regard to investment properties, petitioner listed the
properties (such as the Fontana drive-in, the Fontana coffee
shop, the Kendall drive-in, and the Banning drive-in) under the
land account no. 1210, under the building account no. 1220, or
under the undeveloped or vacant land account.
Some investment
properties were listed under the work-in-progress accounts
temporarily.
Later (after completion of the buildings, though
this is not entirely clear), the properties were moved to land
accounts, building accounts, or undeveloped land accounts.
Presented only with the accounting records and Mr. Baker's
statements, we are not persuaded that Mr. Baker's conclusions
that petitioner's accountants misclassified properties on its
financial records are accurate.
As with its other subdivision properties, petitioner listed
the Exchange Property in the work-in-progress account from 1983
to 1989.
Further, petitioner never moved the Exchange Property
out of the work-in-progress account (even though petitioner
alleges it decided in 1983, or later in 1987-88 after completion
of the 14 lots, not to subdivide the Exchange Property).
This
treatment reflects petitioner's intent to keep the inactive phase
of the 48 lots in the Exchange Property in the work-in-progress
account until development of the houses.
- 46 Improvements
We note that petitioner did not make any improvements on the
Exchange Property.
However, the fact that the property was not
developed when it was sold does not, standing alone, require a
conclusion that it was held for investment.
See Kesicki v.
Commissioner, 34 T.C. 675, 679 (1960).
Activity: Map Process
Petitioner contends that there were little or no activity in
regard to the Exchange Property.
T.C. Memo. 1966-177.
We disagree.
See Olivieri v. Commissioner,
In regard to the Exchange
Property, petitioner resubmitted the tentative map.
tentative map was approved on June 9, 1986.21
The
Afterwards,
petitioner proceeded to obtain a final map regarding the Exchange
Property.
Between May 6, 1986 and May 16, 1989, petitioner
worked with Mr. Dotson, the engineer for city, to revise the
conditions of approval, including the cost estimate.
period, Dotson revised the conditions.
During this
These discussions led to
petitioner being able to lock-in the lower city development fees
for the Exchange Property.
As of March 18, 1988, the final map on the Exchange Property
was approved and ready to be recorded once petitioner obtained
the required signatures.
21
As of the date of the exchange, the
A tentative map shows the design and improvement of a
proposed subdivision and the existing conditions, but it cannot
be recorded. Cal. Govt. Code secs. 66424.5(a), 66429 (West
1997).
- 47 final map had not been recorded by petitioner, but Elkhorn
recorded the final map regarding the Exchange Property on May 16,
1989 (the date of the exchange).
While petitioner de-emphasizes its efforts from 1983 to
1989, petitioner spent time and money in getting the final map
ready to be recorded, from filing applications to discussions
with city employees regarding conditions.
The mapping process is
an involved and time-consuming process.22
While the tentative
map is only a conceptual plan, the final map is a legal document,
which gives the landowner the right to build under certain
conditions.
In explaining petitioner's action regarding the map process,
it asserts that "[a]t the urging of his engineer, Baker
authorized the processing of a new tentative map (No. 22332)."
Later, petitioner asserts that it continued the process "because
that'd be about the only way [it] would ever sell [the property],
is to show someone what could be done on that property."
Petitioner viewed the process of obtaining a tentative map as a
method of determining the economic feasibility of developing
property.
Petitioner notes that the only way a landowner can determine
the feasibility of developing a property is to process a
22
The process of obtaining a final map can take from
6 months to 17 years. It involves numerous stages of review,
comment, and revision until the final map and improvements plans
are approved.
- 48 tentative map.
We note Mr. Dotson's testimony that submitting a
tentative map is not required to determine costs and the
project's profitability.
However, using the process of tentative
maps is one means to determine costs and conditions for
development.
In this case, the tentative map for the Exchange Property
was approved in June 1986.
Afterwards from 1986 to 1989,
petitioner spent 3 years to process the tentative map to the
point the final map was ready to be recorded in 1988.
Petitioner
states that this process indicated that the development would not
be profitable.
In attempting to establish its intent to not
develop the property, petitioner stresses the fact that the final
map was not recorded by petitioner, and that the final map would
have expired in June 1989.
Mr. Garner testified that Mr. Baker
"did not feel that he wanted to go ahead with the recording of
the map.
So we were never given instructions to finish
processing the final map and the street plans."
However, we
agree with Mr. Dotson's statement that he did not assign any
significance to petitioner's waiting to record the final map.
In our view petitioner went further than merely determining
the feasibility of developing the Exchange Property.
Whether
petitioner would have let the tentative map on the Exchange
Property expire is subject to speculation.
However, we know that
petitioner's actions on the Exchange Property made the property
more marketable.
By 1988, the final map was ready to be
- 49 recorded.
Mr. Baker admitted at trial petitioner wanted to sell
the Exchange Property to get its money back.
While petitioner
categorizes this as a vague intent, we find that petitioner
expended substantial time, energy, and money in its efforts to
develop the Exchange Property.
Whether petitioner was going to
get its money back by subdividing and developing the property or
by selling the raw land, it indicates an intent to liquidate the
property.
See Bolker v. Commissioner, 760 F.2d 1039, 1045 (9th
Cir. 1985), affg. 81 T.C. 782 (1983).
Extent of Marketing the Exchange Property
Petitioner points out that it received an unsolicited offer
to purchase the Exchange Property through a broker.
Prior to
receiving the unsolicited offer for the purchase of the Exchange
Property, petitioner did not list the property with a broker for
sale, did not advertise it for sale in any way, and engaged in no
other marketing efforts relating to the Exchange Property.
At the same time, in connection with the 14 lots, petitioner
did not actively market the development; instead, petitioner used
unrelated realtors.
Paullus v. Commissioner
In attempting to demonstrate its investment intent,
petitioner focuses on the fact that it never recorded the final
map of (i.e., never subdivided) the Exchange Property.
Petitioner cites Paullus v. Commissioner, T.C. Memo. 1996-419.
In Paullus, the Court found that the taxpayer held the property
- 50 for investment despite the fact that the taxpayer filed a final
map and constructed about $1,600,000 in off-site improvements
(with the sales price of $11,250,000) on the property.
Id.
Petitioner compares the facts in Paullus to its situation, where
it did not record a final map and constructed no improvements on
the Exchange Property.
Petitioner asserts that its activities
were minor and preliminary compared to those taken by Paullus.
In making its decision, the Court in Paullus looked at
several factors, in addition to the fact of filing a final map
and constructing improvements.
Ridgemark, the taxpayer in
Paullus, segregated its business of operating Ridgemark Golf and
Country Club from the development and sales of lots, which were
done by two other corporations.
Ridgemark consistently reported
its business activity as the operation of a golf and country
club.
The Court noted that Ridgemark's actions (long holding
period, only limited sales to its related companies, paucity of
purchases and sales) indicated an investment motive in holding
the property.
The Court's holding in Paullus was based on the specific
factual situation presented in that case.
While petitioner
argues that the Paullus and this case are similar, we find that
the instant case's factual situation is distinguishable from the
situation surrounding the taxpayer in Paullus.
In Paullus,
Ridgemark formed Ridgemark Financial Corp. and Ridgemark
Construction Corp. to carry on the residential lot activities.
- 51 Ridgemark's main operations were its golf and country club
activities.
By contrast in this case petitioner was in the
subdividing and developing business, choosing to spin off its
fast-food operations to Baker's Burgers, Inc.
While petitioner
asserts its rental activities exceeded its development
activities, we do not find support for that assertion in the
record.
While petitioner did not record the final map, in 1988
it was ready to be recorded.23
As discussed above, petitioner
had taken substantial steps in the development of the Exchange
Property.
Conclusion
Petitioner has been active as a subdivider and developer of
real estate.
It has the burden of proving that when it was
dealing with the Exchange Property it was wearing the hat of an
investor.
Petitioner acquired the Exchange Property to construct
single-family houses for sale.
Considering all the factors, we
find that petitioner did not establish its investor status in
connection with its holding of the Exchange Property.
While
petitioner presented potential obstacles (high development costs,
slow sales, etc.), it did not establish that it discontinued its
plans to develop the 48 lots in the Exchange Property.
23
At the
In a letter by Elkhorn, dated Apr. 11, 1989, it stated
that petitioner was to sign and record the final map before the
exchange. In the end, Elkhorn recorded the final map.
- 52 time of the exchange, petitioner held the Exchange Property
primarily for sale (as evidenced, inter alia, by its effort to
make the final map ready to be recorded, its efforts to lock in
lower city development fees, and its treatment of the Exchange
Property in its books and records).
We conclude that the
Exchange Property was held by petitioner primarily for sale
within the meaning of section 1031(a)(2)(A) and therefore that
the exchange does not qualify for nonrecognition treatment under
section 1031(a).
To reflect the foregoing,
Decision will be entered
for respondent.
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