Homebuilder Lot Sale

[DaveO]

I have a client, a homebuilder, who is selling lots in his own development. He has a contract that states that the purchaser of any lot will hire him to build a home on the lot within 18 months. If they buyer decides not to build he must pay the builder a penalty of $10,000.

The transaction is as follows;
Sale of Lot $220,000
Refund to Buyer $210,000
Profit $10,000

His basis in the lot was $150,000, which was a loan from the bank. When the sale closed he paid off the $150,000 and used the $70,000 profit for other business expenses. When the buyer decided not to build, my client went to the bank and borrowed the $210,000 to refund the buyer’s money less the penalty. He wants to increase the basis in the lot by the $70,000 profit on the transaction. I think he has increased his operating loan by $60,000 and has made a $10,000 profit. Can he increase the lot basis by $60,000? How about the extra $10,000?

[Bees Knees]

At first glance, I tried to fit this into the installment sale rules with a repo on the failed contract. But it can’t fit the installment sale rules because payment is not received over more than one year.

From a tax standpoint, it is actually a contract to re-purchase the lot at a reduced price if the buyer decides not to build. You can’t mix the two transactions together as you could under the installment sale / repossession rules.

When the buyer buys the lot, the seller realizes gain ($220,000 minus $150,000 = $70,000 gain). Then when the seller re-purchases the lot at a reduced rate, the re-purchase price ($210,000) becomes his new cost basis in the lot.

In other words, his profit is still $70,000. His new cost basis is $210,000, which has to be capitalized until he re-sells the lot again.

[jainen]

return of inventory

The lots are inventory, so the profit is ordinary income, not capital gain. I don't see any reason not to charge back the $210K he paid on the return of inventory.

[Snaggletoof]

Capital Gain?

I agree Jainen, but I've reread the posts above, and I don't recall either of them purporting that this should be a capital gain.

Same thing when a realtor sells a house or land. This is not investment property. However, in "real world" how do you handle it when a realtor sells a piece of unimproved property for a gain? Is there not a court case which supports capital gain treatment for as many as 4 concurrent properties??

If you think the realtor should be entitled to capital gain treatment, how many properties does it take to disqualify him?

I would like to know...thanks.

[Bees Knees]

When you are in the trade or business as a homebuilder, lots would be considered inventory and the gain would be ordinary. I don't think there would be any need to count the number of lots sold. A trade or business can't get capital gain treatment simply because there is a low number of sales during the year.

[Unregistered]

Snags might be thinking about §1237 which basically allows for 5 lots to be sold and still have capital gain treatment. There are some strict rules in that section. Don't know if that's what you had in mind but I thought I'd throw it out here.

New York Enrolled Agent

[Bees Knees]

Snags might be thinking about §1237 which basically allows for 5 lots to be sold and still have capital gain treatment.

There's always an exception to the rule. Never say never. Never say always.

Wait...I just said that...

Good catch.

[OldJack]

I guess I really don't fully understand the 5 lot bit. Do you say the first 5 lots are capital gains but the 6th+ lots are ordinary trade or business income? Or, is it that if there are more than 5 lots all the lots are ordinary income? Ref: §1237(b)(1) quoted below.

26 USC Sec. 1237 01/19/04

-EXPCITE-
TITLE 26 - INTERNAL REVENUE CODE
Subtitle A - Income Taxes
CHAPTER 1 - NORMAL TAXES AND SURTAXES
Subchapter P - Capital Gains and Losses
PART IV - SPECIAL RULES FOR DETERMINING CAPITAL GAINS AND LOSSES

-HEAD-
Sec. 1237. Real property subdivided for sale

-STATUTE-
(a) General
Any lot or parcel which is part of a tract of real property in
the hands of a taxpayer other than a C corporation shall not be
deemed to be held primarily for sale to customers in the ordinary
course of trade or business at the time of sale solely because of
the taxpayer having subdivided such tract for purposes of sale or
because of any activity incident to such subdivision or sale, if -
(1) such tract, or any lot or parcel thereof, had not
previously been held by such taxpayer primarily for sale to
customers in the ordinary course of trade or business (unless
such tract at such previous time would have been covered by this
section) and, in the same taxable year in which the sale occurs,
such taxpayer does not so hold any other real property; and
(2) no substantial improvement that substantially enhances the
value of the lot or parcel sold is made by the taxpayer on such
tract while held by the taxpayer or is made pursuant to a
contract of sale entered into between the taxpayer and the buyer.
For purposes of this paragraph, an improvement shall be deemed to
be made by the taxpayer if such improvement was made by -
(A) the taxpayer or members of his family (as defined in
section 267(c)(4)), by a corporation controlled by the
taxpayer, an S corporation which included the taxpayer as a
shareholder, or by a partnership which included the taxpayer as
a partner; or
(B) a lessee, but only if the improvement constitutes income
to the taxpayer; or
(C) Federal, State, or local government, or political
subdivision thereof, but only if the improvement constitutes an
addition to basis for the taxpayer; and

(3) such lot or parcel, except in the case of real property
acquired by inheritance or devise, is held by the taxpayer for a
period of 5 years.
(b) Special rules for application of section
(1) Gains
If more than 5 lots or parcels contained in the same tract of
real property are sold or exchanged, gain from any sale or
exchange (which occurs in or after the taxable year in which the
sixth lot or parcel is sold or exchanged) of any lot or parcel
which comes within the provisions of paragraphs (1), (2) and (3)
of subsection (a) of this section shall be deemed to be gain from
the sale of property held primarily for sale to customers in the
ordinary course of the trade or business to the extent of 5
percent of the selling price.
(2) Expenditures of sale
For the purpose of computing gain under paragraph (1) of this
subsection, expenditures incurred in connection with the sale or
exchange of any lot or parcel shall neither be allowed as a
deduction in computing taxable income, nor treated as reducing
the amount realized on such sale or exchange; but so much of such
expenditures as does not exceed the portion of gain deemed under
paragraph (1) of this subsection to be gain from the sale of
property held primarily for sale to customers in the ordinary
course of trade or business shall be so allowed as a deduction,
and the remainder, if any, shall be treated as reducing the
amount realized on such sale or exchange.
(3) Necessary improvements
No improvement shall be deemed a substantial improvement for
purposes of subsection (a) if the lot or parcel is held by the
taxpayer for a period of 10 years and if -
(A) such improvement is the building or installation of
water, sewer, or drainage facilities or roads (if such
improvement would except for this paragraph constitute a
substantial improvement);
(B) it is shown to the satisfaction of the Secretary that the
lot or parcel, the value of which was substantially enhanced by
such improvement, would not have been marketable at the
prevailing local price for similar building sites without such
improvement; and
(C) the taxpayer elects, in accordance with regulations
prescribed by the Secretary, to make no adjustment to basis of
the lot or parcel, or of any other property owned by the
taxpayer, on account of the expenditures for such improvements.
Such election shall not make any item deductible which would
not otherwise be deductible.
(c) Tract defined
For purposes of this section, the term "tract of real property"
means a single piece of real property, except that 2 or more pieces
of real property shall be considered a tract if at any time they
were contiguous in the hands of the taxpayer or if they would be
contiguous except for the interposition of a road, street,
railroad, stream, or similar property. If, following the sale or
exchange of any lot or parcel from a tract of real property, no
further sales or exchanges of any other lots or parcels from the
remainder of such tract are made for a period of 5 years, such
remainder shall be deemed a tract.

[DaveO]

Capital Gain Treatment is not the question.

We know any income realized is ordinary. The client wants to take basis adjustments to his inventory instead of recognizing the income. He does have $70,000 more cash after the failed sale then before, but he also has $60,000 more debt. The question is can he take a basis adjustment to his inventory (the lot) of $60,000 to avoid showing that as income. The lot won't be resold this year so if he has to recognize the gain he would be paying tax on borrowed money. To me the $10,000 is clearly ordinary gain but he wants to defer that as well. Thanks for all the input.

[Unregistered]

Old Jack

I believe it goes by the tax year. This is a very small snip from the regs.

" When the taxpayer has sold less than 6 lots or parcels from the same tract up to the end of his taxable year, the entire gain will be capital gain."

So for example: If a TP sells 4 lots in 2004 and then another 2 lots from the same parcel of land in 2005, the TP gets full capital gain treatment in 2004 for the first 4 lots. In 2005, the TP then follows the special treatment of §1237 for the 2 lots sold in that year. All of this assumes, the TP is eligible to use §1237 to begin with.

New York Enrolled Agent

[Snaggletooth]

Original Question

As is so often the case, the original question posted has morphed into an entirely different discussion. And that's OK, except in cases where we sail off into the sunset and never address the original question.

I think this guy has profit of $60,000 and a new basis of $210,000, so long as title to the lot actually changed hands. From very early posts, I believe Bees Knees and Jainen have answered the same.

I can understand the customer - as he has not considered this to be realized since he still owes the bank. But a loan per se has never constituted gain or loss by itself. This guy still is $70,000 ahead of the game, and if he spent all this money on operating expenses like Dave-O says, then he has received the deduction for these expenditures.

A more likely scenario which would occur with many of my customers, and with all due respect to DaveO's client, is that as soon as the $70,000 became available, Daddy would buy a boat or a Hummer, or would buy Sonny-Boy a Corvette. Then when the customer defaulted, it's another trip to the bank to borrow the full-up amount.

[Jesse]

Thinking out loud

I don't see how he can defer the $10,000.

As for the $60,000, it would depend on exactly how the contract was written. When would the contract actually be completed? Lesser of 18 months or upon completed contract to build house.

Maybe the $60,000 should have been held in an "escrow" account and the inventory not considered "sold" until either the contractor and customer had a contract to build or the 18 months had elapsed.