We normally think that selling a parcel of land one has held for a long period of time will result in capital gain income subject to federal income tax at a lower rate than ordinary income. A recent court decision reminds us that this is not always the case. Mr. Allen purchased a parcel of real property in 1987. He admitted during pretrial discovery that he purchased the property with the intent of developing it for sale. He attempted to develop the property through 1995 but was not successful. He then spent four years looking for financial partners and developed multiple sets of plans for the development of the property. In 1999, Mr. Allen sold the property to a developer under an agreement that called for him to receive a specified amount each time the developer sold a lot from the property. Mr. Allen received the final installment payment in 2004.

Mr. Allen reported the sale on his tax return as giving rise to a long-term capital gain. Following an audit, the IRS determined that Mr. Allen always intended to sell the property and worked to do so from the date he acquired the property. Therefore, in the IRS’s view, the property was “held primarily for sale” and was not a capital asset in Mr. Allen’s hands.

As a starting point, most kinds of property are capital assets under the definition contained in the Internal Revenue Code. The Code also contains a number of exceptions, however. One exception is any property that is held by the taxpayer primarily for sale. It is well established that when somebody buys a tract of land and then subdivides it and sells individual lots, those lots are not capital assets because the taxpayer bought the land with the intention of selling it. This is a very subjective area because most of the time when somebody purchases an investment, he or she hopes to realize a gain by selling it at some point, yet sales of assets held for investment do give rise to capital gain income in most cases. The court attempts to draw distinctions between situations where a taxpayer purchases something and it appreciates over time and situations where the taxpayer attempts to add value by working to transform the nature of the asset.

The case ended up in the United States District Court for the Northern District of California. The court determined that Mr. Allen purchased the property with the intent to develop and sell it and was actively involved in attempting to develop the property for the sale of lots. While Mr. Allen claimed that he had abandoned his development efforts, the court found that he had not done anything to demonstrate when or why his intent changed with respect to the property.

An interesting aspect of the court’s analysis centers on the fact that Mr. Allen made only a single sale with respect to the property. It is a commonly held view that one cannot be viewed as holding property primarily for sale if the owner disposes of it in a single-sale transaction. The court noted that any notion of a “one-bite” rule, in the words of the court, has been rejected in other cases.

The takeaway from this case is that if you purchase property intending to develop it but later change your mind, you need to do something visible and provable that will document your changed intention regarding the property. For example, if you had applied for a subdivision map or other entitlements, withdrawing your application could be used later as evidence of your changed intention regarding the property. This case reminds us that selling the property in a single-sale transaction may not be enough to generate capital gain income, even where the property had been held for 12 years.