The Tax Court has held in D.L. White Construction, Inc., TC Memo. 2010-141 that a corporation engaged in the business of residential real estate construction could not claim the cost of acquiring unimproved real estate as the cost of goods sold or alternatively deduct that amount as a Code Sec. 165(a) business loss where its easement to access the property through adjacent land was challenged in the courts.
Background on cost of goods. In a manufacturing, merchandising, or mining business, gross income means total sales less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. (Reg. § 1.61-3(a)) The amount that a taxpayer claims as cost of goods sold is not subject to the limitations on deductions found in Code Sec. 162 (ordinary and necessary trade or business expense) and Code Sec. 274 (substantiation requirements). Rather, it is treated as a subtraction from gross sales to arrive at a qualifying business’ gross income. (Metra Chem Corp. (1987), 88 TC 654) As a general rule, where the production, purchase, or sale of merchandise of any kind (inventory) is an income-producing factor, inventory on hand at the beginning and end of the year is taken into account in computing the taxable income for the year. If a taxpayer must use an inventory, a taxpayer ordinarily is required to use the accrual method. (Reg. § 1.446-1 , Reg. § 1.471-1) Real property is not generally merchandise for purposes of inventory accounting. (W.C. & A.N. Miller Dev. Co. (1983), 81 TC 619)
Background on business loss deduction. Under Code Sec. 165(a), a taxpayer may deduct a loss sustained during the tax year and not compensated for by insurance or otherwise. To be allowable under Code Sec. 165(a) , the loss must be evidenced by a closed and completed transaction, fixed by identifiable events, and actually sustained during the tax year. If a taxpayer has a claim for reimbursement on which there’s a reasonable prospect of recovery, that “reimbursable” loss can’t be deducted until it’s reasonably certain the reimbursement will or will not be made. This may be ascertained by, among other things, settlement, adjudication or abandonment of the claim. (Code Sec. 165(a), Reg. § 1.165-1(d))
Facts. D.L. White Construction, Inc. (White Construction), is a C corporation that uses the cash method of accounting and a fiscal year ending on September 30. It’s in the business of residential real estate construction. During its 2002 tax year, it bought four parcels of adjoining land in northern Idaho (the Blossom Mountain property), totaling approximately 80 acres, for $290,000 ($90,000 of which was financed through a promissory note). It planned to build four homes on the Blossom Mountain property and sell the homes at a profit. However, to reach the Blossom Mountain property, White Construction used an access road that crossed an adjoining property owned by Mr. and Mrs. Akers. On January 10, 2002, the Akerses filed suit against White Construction in the Idaho district court for negligence and trespass and to quiet title.
White Construction filed its Form 1120, U.S. Corporation Income Tax Return, for the 2002 tax year. It included the $220,000 it spent on the Blossom Mountain property in its cost of goods sold. Although the Akerses’ lawsuit was still ongoing when it filed its Form 1120, White Construction claimed the $220,000 amount because it didn’t have legal access to the Blossom Mountain property and contended that the property was worthless.
The Blossom Mountain litigation was protracted. On January 3, 2003, the Idaho district court found that White Construction did not have a complete easement over the Akerses’ property, had trespassed, was negligent, and had engaged in malicious conduct. On April 1, 2004, the district court reheard the case, again finding against White Construction. This decision was appealed, and the Idaho Supreme Court remanded the case to the district court. On October 6, 2006, the district court again found against White Construction. This decision was appealed, and the case was once again remanded to the district court. On January 22, 2009, the Idaho Supreme Court withdrew its latest decision to remand, and, affirming the district court in part and vacating its judgment in part, once more remanded the case for further proceedings.
After the Idaho district court issued its April 1, 2004 decision, White Construction’s title company’s insurer issued White Construction a $200,000 check.
On audit of the 2002 tax year, IRS reduced White Construction’s cost of goods by $220,000. White Construction sought relief in court, where it acknowledged that its deduction for cost of goods sold might have been incorrect, but argued that it nevertheless should be able to deduct the $220,000 amount as a Code Sec. 165 business loss.
Decision on cost of goods argument. The Tax Court concluded that even if the Blossom Mountain property were properly classified as inventory, White Construction would not be entitled to include the cost of the property in its cost of goods sold.
After first noting the oddness of the fact that White Construction apparently used an inventory in its business even though it claimed to be a cash basis taxpayer, the Court assumed for the sake of argument that merchandise was an income-producing factor in its business and that it was required to use an inventory. That being the case, the Court concluded that White Construction failed to prove that the Blossom Mountain property was merchandise properly includable in calculating its cost of goods sold. White Construction also failed to prove that the Blossom Mountain property, even if properly classified as merchandise includable in inventory, should not have been included in closing inventory for purposes of calculating its cost of goods sold. White Construction continued to own the property on September 30, 2002, and failed to show that it was worthless as of that date.
Decision on business deduction argument. The Court found that White Construction failed to prove any of the elements for a deduction under Code Sec. 165. Its claimed loss for the Blossom Mountain property was not evidenced by a closed and completed transaction, fixed by identifiable events. As of the close of White Construction’s 2002 tax year, the Idaho district court had not issued its first opinion in the lawsuit-a lawsuit that the Court noted was still unresolved. Further, White Construction failed to show that the claimed loss was actually sustained during its 2002 tax year or in any other year. While contending that the Blossom Mountain property was worthless because there was not any access to the property, White Construction continued to own the property. There was no credible evidence that White Construction could not acquire access to the property in some other way or that the property had become worthless as of September 30, 2002. In addition, even if it did establish that it sustained a $220,000 loss with respect to the Blossom Mountain property during the tax year 2002, it still could not deduct the loss because it had a reasonable prospect of recovery as of the end of the year since it had a claim under its title insurance policy. Indeed, White Construction actually received reimbursement of $200,000 for its loss.
For more information about this case or tax planning for real estate developers, contact Moore McLaughlin, Esq. at MMcLaughlin@McLaughlinQuinn.com or by phone at 401-421-5115 ext. 212.
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