Case Study: Beneficial Capital Gain Treatment Allowed for Real Estate Developer
In one pro-taxpayer decision, the 11th Circuit Court of Appeals concluded that more than $5 million of proceeds from selling rights to buy land and build a luxury condo project counted as lower-taxed long-term capital gain rather than higher-taxed ordinary income. The decision reversed an earlier U.S. Tax Court decision.
Facts of the Case
The taxpayer, Philip Long, was a real estate developer who operated his business as a sole proprietorship. In 2006, he received $5.75 million in exchange for selling contract rights that he had obtained as a successful plaintiff in a lawsuit. The lawsuit involved the rights to buy a piece of land in Fort Lauderdale, Florida, and build a luxury condominium tower on that land.
After auditing the taxpayer’s 2006 federal income tax return, the IRS served the taxpayer with a notice of deficiency indicating that he had taxable income of $4,145,423 in 2006 and owed $1,430,743 of federal income tax for that year. Among other things, the IRS claimed that the $5.75 million received by the taxpayer was in lieu of future ordinary income payments and should therefore be counted as ordinary income under the “substitution for ordinary income doctrine.”
Long claimed that the $5.75 million should be taxed as long-term capital gain. Thanks to the lawsuit, the taxpayer owned an option to buy the land underlying the condo project along with the right to build the condo tower itself, which he had been working on for some 13 years. Essentially, the IRS said: “too bad.” The taxpayer took his case to the Tax Court.
Unfortunately for him, the court agreed with the IRS that the $5.75 million constituted ordinary income because, according to the court, he intended to sell the land underlying the condo project land to customers in the ordinary course of his business.
The Circuit Court’s Decision
The 11th Circuit Court decision starts off by noting that gain from selling a capital asset that a taxpayer has held for more than a year constitutes long-term capital gain that is taxed at preferential rates. In contrast, ordinary income is taxed at higher rates. The term “capital asset” means property held by the taxpayer (whether or not connected with his business), but does not include property held by the taxpayer primarily for sale to customers in the ordinary course of his business. In certain circumstances, contract rights can qualify as capital assets.
The 11th Circuit pointed out that the Tax Court had erred by mistakenly concluding that Long sold the land underlying the condo project for the $5.75 million. In fact, the taxpayer never actually owned the land. What he sold was the exclusive right to purchase the land pursuant to the terms of the condo development agreement and the associated right to build the condo tower. As stated earlier, he won these rights in a legal judgment rendered by a Florida court.
Therefore, the real issue was whether Long held the contract rights primarily for sale to customers in the ordinary course of his business. The 11th Circuit found no such evidence. Instead, the evidence showed that Long always intended to develop the condo project himself until he finally decided to sell his rights.
The 11th Circuit also rejected the government’s argument that the $5.75 million received by Long was in lieu of future ordinary income payments and should therefore be counted as ordinary income under the “substitution for ordinary income doctrine.” According to the appeals court, the rights that Long sold only represented the potential to earn income in the future based on the owner’s actions and on future events that could not be fully foreseen. Rights to earn future undetermined income (as opposed to rights to receive income that has already been earned) constitute a capital asset.
Finally, the 11th Circuit concluded that Long had owned the contract rights for more than one year because they resulted from a lawsuit that was filed in 2004. Since the contract rights constituted a capital asset that Long had owned for more than one year (he sold the rights in 2006), he was entitled to treat the $5.75 million as lower-taxed long-term capital gain. The Tax Court’s earlier decision to the contrary was reversed. (Philip Long, 11th Cir. 2014)
Moral of the Story
It is almost always better to be able to characterize income or profit as capital gain rather than ordinary income. As the decision described in this article illustrates, capital gain treatment may be available in situations that might surprise you. Consult your tax adviser whenever you face the capital-gain-versus-ordinary-income issue, and be aware that it might be lurking in the background when you least suspect it.