Patton, Norman T.

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Case Western Reserve University School of Law

Case Western Reserve Law ReviewVolume 11 | Issue 21960Special Problems of Real Estate--Charitable Gifts,Apportioning Costs, and Dealer Versus InvestorStatusNorman T. PattonFollow this and additional works at: https://scholarlycommons.law.case.edu/caselrevPart of the Law CommonsThis Symposium is brought to you for free and open access by the Student Journals at Case Western Reserve University School of Law ScholarlyCommons. It has been accepted for inclusion in Case Western Reserve Law Review by an authorized administrator of Case Western Reserve UniversitySchool of Law Scholarly Commons.Recommended CitationNorman T. Patton, Special Problems of Real Estate--Charitable Gifts, Apportioning Costs, and Dealer Versus Investor Status, 11 Wes. Res. L.Rev. 253 (1960)Available at: https://scholarlycommons.law.case.edu/caselrev/vol11/iss2/14DISPOSITION OF REAL ESTATETax Problems Incident To the Disposition of Real EstateVSPECIAL PROBLEMS OF REAL ESTATE - CHARITABLE GIFTS,APPORTIONING COSTS, AND DEALER VERSUS INVESTOR STATUSNorman T. PattonCHARITABLE CONTRIBUTION DEDUCTIONS AND GIFTSOF REAL ESTATEThe use of appreciated stocks and securities when making charit-able contributions is a rather common practice. This same possibilityfor tax saving is sometimes overlooked where the donor has appreci-ated real estate. By donating the real estate to a charitable organiza-tion, educational institution, or other organization designated in sec-tion 170 (c) of the Internal Revenue Code of 1954, the donor avoidsthe payment of the capital gain tax that would result if he were tosell the appreciated property,1and he is permitted to take aTHH AUTHOR (B.A., 1941, Western Reserve, charitable contribution deduc-LL.B., 1950, Cleveland Marshall Law School) tion based on the fair marketis a Cleveland attorney, value of the property at thetime of the gift.2 The taxsavings will depend upon the tax bracket of the donor.Even greater tax benefits are available where appreciated prop-erty is sold to a charitable organization at cost. For example, sup-pose a taxpayer who holds real estate for investment which cost him$1,000 and which now has a fair market value of $1,500, desires tomake a charitable contribution of $500. The individual could con-tribute $500 in cash, which would be the most expensive way, to him,of making the contribution; or he could contribute one-third of theparcel, which would be a less expensive way of making an equivalentcontribution.3 However, the least expensive way of making the con-tribution would be for the taxpayer to sell the entire parcel to thecharitable organization for his original cost of $1,000. By so doing,he would be allowed to recover his original cost tax free, and, in addi-tion, he would be entitled to a charitable contribution deduction of1. Rev. Rul. 138, 1955-1 CuM. BULL. 223. A dealer in real estate could avoid ordinary in-come tax by a contribution of appreciated real estate to a charitable organization.2. Treas. Reg. § 1.170-1(e) (1958).3. This assumes that $500 would be the equitably apportioned cost basis for the one-thirdparcel. For a discussion of apportioning the cost see notes 7-10 infra and accompanying text.1960]WESTERN RESERVE LAW REVIEW$500, the difference between the fair market value of the propertyand the selling price of the property to the charitable organization.Thereafter, if the individual so desires, he could purchase a similarparcel and obtain a new basis for the property equal to its purchaseprice, which, assuming the purchase price to be $1,500, would step-up his basis by $500 without his ever having incurred any income taxliability to obtain such a step-up.4Where there is a possibility that the limitation on charitable con-tribution deductions will apply,5 the taxpayer may spread a gift ofreal property over two or more years by giving only a part of theproperty in each year.'APPORTIONING COST WHERE LESS THAN THE ENTIRE TRACTIs SOLDWhere a tract of land has been carried as one account and a saleis made of less than the whole, it is necessary to treat each such saleas a separate and complete transaction. This means that the cost ofthe entire tract must be apportioned between or among the parts,and, further, that this apportionment must be done on an equitablebasis, as distinguished from a ratable basis.7Some of the methods that are commonly used are the front foot-age method,' the assessed valuation method,9 and the tentative salesprice method. 10 This third method is especially useful in the case ofa subdivision for a housing development, where some lots will carryhigher selling prices than others. Under this method, each lot willcarry the same percentage of the overall cost as its estimated sellingprice is to the total estimated selling price.In determining the apportionment of cost among the various lotsof a subdivision, it is important to include an estimate of future ex-penditures that will be made and which will benefit all of the lots ofthe subdivision."4. If the property were sold to a charitable organization for $1,200, the transaction wouldhave the dual nature of a part sale, part gift; the transferor is entitled to a $300 charitable con-tribution deduction and is required to report a $200 capital gain as a result of the transaction.See Treasury Department Letter Rulings to Robert L. Merritt, Esq., dated September 15, 1959,and October 1, 1959, signed by Lester W. Utter, Chief, Individual Income Tax Branch, bearingsymbols "T:R:I: DMO-3."5. See INT. REV. CODE OF 1954, § 170(b).6. See Merritt, The Tax Incentives for Charitable Giving, 36 TAXES 646, 647, 653-54(1958).7. Treas. Reg. § 1.61-6 (1951).8. Biscayne Bay Islands Co., 23 B.T.A_ 731 (1931).9. J. S. Cullinan, 5 B.T.A. 996 (1927).10. R. W. Ewing, 27 P-H Tax. Ct. Mem. 533 (1958).11. The Colony, Inc., 26 T.C. 30 (1956), aff'd and rev'd on other issues, 244 F.2d 75 (6thCir. 1957) and 357 U.S. 28 (1958).[MW6DISPOSITION OF REAL ESTATEDEALER AND INVESTOR PROBLEMSThe continuing attempt on the part of taxpayers to have profitstreated as capital gains rather than ordinary income has been especial-ly apparent in transactions involving real estate. The basic rule thata dealer in real estate has ordinary income and an investor has capi-tal gain is well recognized. 12 The problem is to determine who is adealer and who is an investor, and further, at what point an investortakes on the dealer label.Numerous courts have decided these questions, based upon theparticular facts of each case. These decisions provide a pattern asto what can and what cannot be done if a dealer status is to beavoided. Generally, a dealer status may be recognized when one ormore of the following factors are present:1. Sales of real property are frequent and continuous rather thanisolated and casual;132. The taxpayer or his agent engages in advertising and promo-tional work with respect to the sale of the real estate;' 43. The taxpayer either maintains a real estate office or is a licensedreal estate broker;154. The taxpayer expends funds in improving the property;165. The taxpayer subdivides a large tract and sells lots;' 76. The taxpayer acquires real estate under circumstances that indi-cate a non-investment intent' 8On the other hand, the absence of the above factors would workin favor of an investor status.It is interesting to note that one taxpayer may be considered aninvestor with respect to some transactions and a dealer with respectto others.' 9 Anyone who anticipates this position should make a spe-cial effort to maintain records which will show dearly his status asto each transaction entered into. Consideration should also be givento the use of one or more corporattions in this type of situation, if theuse of multi-corporations can be justified.2012. INT. RE V. CODE OF 1954, § 1221.13. Burgher v. Campbell, 244 F.2d 863 (5th Cir. 1957); Estate of . M. Webb, 30 T.C.1202 (1958); E. Aldine Lakin, 28 T.C. 462 (1957); August Engasser, 28 T.C. 1173 (1957).14. J. U. Philbin, 26 T.C. 1159 (1956); T. W. Briggs, 25 P-H Tax Ct Mem. 350 (1956).15. Jones v. Commissioner, 209 F.2d 415 (9th Cir. 1954); Durr v. Usry, 163 F. Supp. 355(E-D. La. 1958).16. Ray E. Dugan, 26 P-H Tax Ct. Mem. 706 (1957).17. Lewis L. Culley, 29 T.C. 1076 (1958).18. Clark v. United States, 143 F. Supp. 165 (S.D. Cal. 1956); Albert Winnick, 21 T.C.1029 (1954), aff'd without opin., 223 F.2d 266 (6th Cir. 1955).19. Rev. Rul. 565, 1957-2 Cum BULL. 546; D. G. Bradley, 26 T.C. 970 (1956), acq.,1957-1 Cum BULL. 3; D. L Phillips, 24 T.C. 435 (1955), acq., 1956-2 CuM. BULL. 7;J. 0. Chapman, 13 P-H Tax Ct. Mem. 44 (1944).20. But see James Realty Co. v. United States, 176 F. Supp. 306 (D. Minn. 1959).1960]WESTERN RESERVE LAW REVIEWSUBDIVISION OF REAL ESTATEPrior to the enactment of section 1237 of the Internal RevenueCode of 1954, an investor who subdivided and sold real estate waslikely to be taxed at ordinary income rates.21 Section 1237 was ad-ded to give relief to individual or corporate investors who found itnecessary to subdivide a tract in order to realize the greatest profiton their investment.22In order to qualify as an investor under this section, an individualmust show that: (1) he was not a dealer in other real estate in theyear of sale; (2) he never held the subdivided tract as a dealer;(3) he had held the tract for at least five years, if it was not in-herited; and (4) he did not make substantial improvements. 3 Withregard to improvements, the code provides that they shall be deemedto have been made by the taxpayer if such improvements were madeby the taxpayer or members of his family,24 by a corporation con-trolled by the taxpayer, or by a partnership in which the taxpayer isa partner; 25 or if made by a lessee (provided such improvement con-stituted income to the taxpayer) ;26 or if made by any governmentalor political subdivision (provided the improvement constituted anaddition to basis for the taxpayer).In addition to the above tests, in order for a corporation to qual-ify under section 1237 it must not have a shareholder who holdsproperty as a dealer, or who holds a controlling interest in anothercorporation which so holds real property or which, except for section1237, would be so considered to hold real property.28 Further, theproperty involved must have been acquired through the foreclosureof a lien, which lien secured the payment of an indebtedness to acreditor who has transferred the foreclosure bid to the corporationin exchange for all of the stock of the corporation and other con-sideration.29If the above tests are met, the code provides that the propertyshall not be considered as being held primarily for sale to customersin the ordinary course of trade or business solely because of the sub-21. Palos Verdes Corp. v. United States, 201 F.2d 256 (9th Cit. 1952); Mauldin v. Com-missioner, 195 F.2d 714 (10th Cir. 1952); Brown v. Commissioner, 143 F.2d 468 (5th Cit.1944); Shearer v. Smyth, 116 F. Supp. 230 (N.D. Cal. 1953).22. INT. REv. CODE OF 1954, § 1237. See Senate Finance Comm. Reports, S. REP. No.1622, 83d Cong., 2d Sess. (1954); Conference Report, H.R. REp. No. 2543, 83d Cong., 2dSess. (1954).23. INT. REV. CODE OF 1954, §§ 1237 (a) (1), (2), (3).24. "Members of family" is defined in INT. REV. CODE OF 1954, § 267 (c) (4).25. INT REV. CODE OF 1954, § 1237 (a) (2) (A).26. INT. REV. CODE OF 1954, § 1237 (a) (2) (B). For a discussion of when improvementsby lessee may constitute income to the lessor see p. 189.27. INT. REV. CODE OF 1954, § 1237 (a) (2) (C).28. INT. REv. CODE OF 1954, § 1237 (a).29. Ibid.;Treas. Reg. § 1.1237-1(c) (5) (iv) (1957).[AlarchDISPOSITION OF REAL ESTATEdivision and sale of such property or because of any activity incidentto this subdivision or sale.30In addition to the above provisions, even if the owner of thetract makes improvements, they will not be deemed to be "substan-tial improvements,"31 if the tract is held for ten years32 and if: (1)the improvement consists of the building or installation of water,sewer, or drainage facilities or of the construction of roads; (2) thelot or parcel would not have been marketable at the prevailing pricefor similar building sites without such improvements; and (3) thetaxpayer elects to make no adjustment to the basis of the lot or par-cel, or any other property owned by the taxpayer, on account of theexpenditures for such improvements.33The tax benefits which a taxpayer may derive from qualifyingunder section 1237 are of notable significance and should not be over-looked by anyone involved in this type of enterprise. If no morethan five lots or parcels contained in the same tract of real estate aresold or exchanged, the gain from such sale or exchange will be con-sidered a capital gain.34 If a sixth lot or parcel is sold, however, thegain from all lots sold in the year of the sixth sale or subsequentyears will be deemed to have been gained from the sale of propertyheld primarily for sale to customers in the ordinary course of busi-ness.35  But even in this situation the taxpayer is benefited under sec-tion 1237 because the gain will be taxed as ordinary income only tothe extent of five per cent of the selling price; the balance of the gainwill still be capital in nature. Moreover, the expenditures incurredin connection with such sales or exchanges may be offset against thatportion of the gain that is taxed as ordinary income. 36  Thus, evenwhen more than five lots are sold or exchanged, the entire gain maybe taxed as a capital one after the expenditures have been taken intoconsideration. In view of this, any real estate investor who mayhave to subdivide a tract should engage in careful planning and tim-ing in order to insure that he will come within the provisions of sec-tion 1237 and that he will be able to obtain the maximum benefitswhich this section offers.30. INT. REV. CODE OF 1954, § 1237(a).31. Which, under § 1237 (a) (2) would disqualify the land as being held for an investment.32. It should be noted that the property must be held a full ten years. Compare this withthe general five-year rule, § 1237(a) (3).33. INT. RnV. CODE OF 1954, § 1237(b) (3). The second and third requirements need notbe met if the property was acquired by foreclosure of a lien thereon which secured an indebted-ness to the taxpayer, or, if the property is adjacent to property so acquired if at least 80% ofthe property owned by the taxpayer is property acquired in that manner. Ibid. For a discus-sion of the similar provision in regard to corporations, see note 28 supra and accompanyingtext.34. INT. REV. CODE OF 1954, § 1237(b) (1).35. Ibid.; Treas. Reg. § 1.1237-1(e) (2) (1957). This section of the regulations providesthat in computing the number of lots sold, two or more contiguous lots sold to a single buyerin a single sale will be counted as only one lot.36. INT. RE.m CODE OF 1954, § 1237(b) (2); Treas. Reg. 5 1.1237-1(e) (2) (1957).1960]

Special Problems of Real Estate--Charitable Gifts, Apportioning Costs, and Dealer Versus Investor Status

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Special Problems of Real Estate--Charitable Gifts, Apportioning Costs, and Dealer Versus Investor Status

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