Timothy Phelan, along with two other investors, purchased a 1,050-acre parcel of vacant land for investment. They formed the Jackson Creek Land Co. (JCLC) partnership to hold title for long-term appreciation in market value.

During the next few years, the local improvement district brought water and sewer pipes to the property.

Purchase Bob Bruss reports online.

Four years after purchase, JCLC sold 102 acres to a home builder. The profit was $607,344. Later, the same year another portion of the land was sold to another home builder at a profit.

Phelan reported his profit shares as long-term capital gains on his income tax returns. But the IRS argued these profitable land sales should be taxed at the higher ordinary income tax rate because JCLC was really in the land development business.

However, Phelan replied the land was held for long-term investment and the development activity was minimal. The taxpayer noted bringing the water and sewer service to the property was contracted by a prior owner of the land.

Phelan cited Internal Revenue Code 1221(1), which defines a capital asset as “property held by the taxpayer…but does not include…property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

The investors explained that only two land sales were made during their four years of ownership, they were not real estate licensees, and did not have the land listed for sale.

If you were the tax court judge would you rule the land sale profits were long-term capital gains, or ordinary income for property sold in the course of business?

The U.S. Tax Court judge ruled the land sale profits were long-term capital gains.

The first criteria for determining if an investment property sale profit is a long- or short-term gain, the judge began, is the length of the holding period. In this case, the holding period was well over the 12-month minimum for a long-term capital gain, he noted.

The second criteria for taxation of sales of vacant land is whether the seller is in the business of developing real estate, such as by making improvements, and promoting sales, he continued. The facts show Phelan and his partners made minimal improvements, such as bringing water and sewer pipes to the property as contracted by a previous owner, the judge explained.

The third and most important criterion is the frequency of land sales, the judge opined. In this situation, the investors held the land for four years before selling two portions to home builders, he emphasized.

Due to the infrequency of land sales, lack of marketing efforts and other evidence the land was purchased as a long-term investment, the profits on the land sales qualify for the lower long-term capital gains tax rate, the judge concluded.

Based on the 2004 U.S. Tax Court decision in Phelan v. Commissioner T.C. Memo 2004-206.

(For more information on Bob Bruss publications, visit his
Real Estate Center


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