Fraley v. Commissioner
| Decision Date | 14 July 1993 |
| Docket Number | Docket No. 10808-91. |
| Citation | 66 T.C.M. 100 |
| Parties | Oscar M. Fraley and Magdaline R. Fraley v. Commissioner. |
| Court | U.S. Tax Court |
John R. James, 77 N. Miller Rd., Fairlawn, Ohio, for the petitioners. Mario J. Fazio, for the respondent.
Memorandum Findings of Fact and Opinion
Respondent determined a deficiency in petitioners' Federal income tax for the taxable year 1987 in the amount of $43,164.07. Respondent also determined additions to tax under section 6653(a)(1)(A) in the amount of $2,158, under section 6653(a)(1)(B) in the amount of 50 percent of the interest due on $43,164.07, and under section 6661(a) in the amount of $10,791.
All section references are to the Internal Revenue Code in effect for the year before the Court, and all Rule references are to the Tax Court Rules of Practice and Procedure. The issues for decision are:
1. Whether a certain parcel of land was held primarily for sale to customers in the ordinary course of a trade or business or was held for investment, which will determine whether the gain on the sale of that land is taxable as ordinary income or as capital gains.
2. Whether the adjusted basis of that parcel of land is $77,273.45, as reported on petitioners' tax return, or $37,212, as determined by respondent.
3. Whether petitioners are liable for additions to tax for negligence under section 6653(a)(1)(A) and (B) and for a substantial understatement of income tax under section 6661(a).
Some of the facts have been stipulated and are so found. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.
Petitioners Oscar M. Fraley and Magdaline R. Fraley are husband and wife, and at the time they filed their petition they resided in Fairlawn, Ohio. Mrs. Fraley is a homemaker who is not employed outside of the home. However, she performs secretarial services for her husband's construction business. Petitioner Oscar M. Fraley is a building contractor who operates his business as a sole proprietorship. The term petitioner in the singular will hereinafter refer to petitioner Oscar M. Fraley.
Petitioner's entire working life of almost 40 years has been devoted to the construction of single-family homes and remodeling work. He customarily purchases parcels of land, usually lots in a subdivision that has already been developed to the extent of water and sewer lines, roads, and curbs; i.e., the usual improvements to subdivided building lots. Petitioner then builds single-family homes on these building lots. He either builds the house to the home buyer's specifications or builds a house on speculation and later seeks a buyer for that house. At times during the years from 1979 through 1985, petitioner served on the Fairlawn Planning Commission and thus was generally aware of promising areas in the local real estate market. Petitioner has worked consistently as a builder of single-family houses but generally on a relatively small scale.1 He does not customarily buy large tracts of land, subdivide them, and sell building lots as such.
In 1979 petitioner purchased real property located at 2844 Smith Road, Fairlawn, Ohio (hereinafter the Smith Road property). The total purchase price of the Smith Road property was $75,100. The Smith Road property contained approximately 1.97 acres. The Smith Road property was zoned R-1 for residential use only. There was an existing house on the property that was occupied by the property owner. After petitioner purchased the Smith Road property, he made substantial improvements to the house and rented it in 1980 and 1981. In December of 1981, petitioner removed the house from the Smith Road property, relocated the house to another parcel of land, and sold the house.2
Petitioner then held the Smith Road land from 1981 until its ultimate sale in 1987. Throughout that holding period and to the present time, that land has remained zoned for residential use only. After the house was removed from the Smith Road property, petitioner placed a sign on the land reading "SMITH ROAD WILL BUILD TO SUIT * * * 2.8 ACRES". The sign listed petitioner's telephone number. The 2.8 acres included petitioner's 1.97 acres in the Smith Road property plus an additional .83 acres belonging to John R. James3 (hereinafter James). A single-family home could have been built on petitioner's 1.97 acres because he had sewer and water lines on the front of his property. James did not have sewer or water service to his parcel of land and could not obtain such service because he had no street access. James asked petitioner to let him run sewer and water lines across petitioner's Smith Road property over to James' parcel, but petitioner declined to do that. Thus, James' parcel of land had little or no development potential. At some point, apparently in late 1981 or early 1982, when the "Will Build to Suit" sign was first erected, petitioner and James had agreed to put their parcels together, to hold them for appreciation, and to sell them as a single tract of land. Petitioner never contemplated building a single-family house on the Smith Road property, but had in mind some type of business or commercial building. He and James put up the "Will Build to Suit" sign in order "to whet the appetite" of the owner of the adjacent commercial property, GenCorp. No improvements were ever made to either James' parcel or petitioner's Smith Road land.
Petitioner obtained an appraisal of his Smith Road property, dated May 13, 1981. The appraiser determined that the highest and best use was limited business, which would require a zoning change to B-1, limited business. With such a zoning change, the appraiser valued petitioner's Smith Road property at $130,000.
About the end of 1986, James received inquiries from the adjacent landowner, GenCorp, about the possible purchase of his small parcel. GenCorp held a large adjacent parcel of land zoned commercial and particularly wanted to acquire James' property in order to square off the GenCorp land, to prevent undesirable development adjacent to its land, and also to "land bank" real estate in the area. James would not sell to GenCorp unless the company purchased both his land and petitioner's Smith Road property.
About the time these negotiations commenced in late 1986, petitioner removed the "Will Build to Suit" sign from the property. James and petitioner rejected offer after offer that was made by GenCorp, holding out for the top dollar for their land. The GenCorp negotiator contacted many local real estate brokers to try to determine the fair market value of the two parcels. He received many differing valuation figures. Ultimately, GenCorp purchased both the James' property and petitioner's Smith Road property. Petitioner sold his unimproved Smith Road land to GenCorp on April 15, 1987, for $359,220.
On their 1987 Federal income tax return, petitioners reported the sale of the Smith Road property on Schedule D as the sale of a capital asset. Petitioners reported a basis of $77,273.45 and thus capital gain income in the amount of $281,946.55.
There is no evidence in the record to explain or substantiate petitioners' $77,273.45 basis figure. At trial petitioners contended that, in the course of an audit of their 1981 tax return, respondent had determined an original cost basis of $25,000 for the house located on the Smith Road land at the time petitioner acquired the property in 1979. Therefore, petitioners argue that the basis for the land itself would be the original purchase price of $75,100 less the $25,000 for the house or $50,100. See supra note 2. The audit of petitioners' 1981 return resulted in the issuance of a "no change letter" by the Internal Revenue Service (IRS). The record does not establish that the IRS made any determinations as to the basis of the house or as to any other item on the 1981 return.4
Respondent utilized the 1978 County Real Estate Taxes and Special Assessments form to determine the basis in the Smith Road property. That County form assigned values to the house and to the land. Using that County tax assessment figure, respondent determined that the basis for the Smith Road land was $37,212.
1. At the time of the sale of the Smith Road land in 1987 and for several years prior thereto, petitioner held that land for investment purposes.
2. The portion of the original purchase price of the Smith Road property allocable to the land was $37,212, which was the proper basis for the land in 1987.
3. Petitioners were negligent in claiming a basis for that unimproved land that exceeded the original purchase price of both the land and the house originally located thereon.
OpinionPetitioner contends that he held the Smith Road land for investment purposes and therefore it was a capital asset, the sale of which resulted in capital gains. Respondent contends that petitioner held that land primarily for sale to customers in the ordinary course of his trade or business and therefore it was not a capital asset, so that the sale thereof resulted in ordinary income. Petitioner bears the burden of proving that the Smith Road land is a capital asset and that respondent's determination is erroneous. Rule 142(a); Guardian Industries Corp. v. Commissioner [Dec. 47,610], 97 T.C. 308, 316 (1991).
Section 1221(1) defines the term "capital asset" as property held by the taxpayer (whether or not connected with his trade or business), but expressly excludes, among other items, "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business". The Supreme Court has noted that the purpose of this provision is
to differentiate between the "profits and losses arising from everyday operation of a business" on the one hand * * * and "the realization of appreciation in value accrued over a substantial period of time" on the other. * * *
Malat...
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