                         T.C. Memo. 2011-137



                       UNITED STATES TAX COURT



          MARK S. AND CHERYL R. GARDNER, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15676-09.                Filed June 20, 2011.



     Gregory P. White, for petitioners.

     Molly H. Donohue and Mary P. Hamilton, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     HALPERN, Judge:    Respondent determined a $39,059 deficiency

in, and a $9,764.75 addition to tax with respect to, petitioners’

2004 Federal income tax.

     The parties have resolved several of the adjustments giving

rise to that deficiency, and some are only computational.    They

have left two issues for us to decide:    (1) The character of gain
                               - 2 -

realized on petitioner husband’s disposition of a portion of one

parcel of real property and (2) his purpose in holding a second

parcel of real property.   Petitioners assigned no error to

respondent’s determination of the addition to tax (for failure to

file timely their 2004 return), nor do they address it on brief,

beyond conceding that they were late in filing that return.      We

assume, therefore, that they concede their liability for the

addition to tax (adjusted to take account of the deficiency we

redetermine), and we shall not further address it.   See Rule

151(e)(4) and (5); Sundstrand Corp. & Subs. v. Commissioner, 96

T.C. 226, 344 (1991).

     Unless otherwise stated, section references are to the

Internal Revenue Code in effect for 2004, and Rule references are

to the Tax Court Rules of Practice and Procedure.

     Petitioners bear the burden of proof.   See Rule 142(a).1




     1
      Petitioners have not raised the issue of sec. 7491(a),
which shifts the burden of proof to the Commissioner in certain
situations. We conclude that sec. 7491(a) does not apply here
because petitioners have not produced any evidence that they have
satisfied the preconditions for its application.
                               - 3 -

                         FINDINGS OF FACT

Introduction

     Some facts have been stipulated and are so found.    The

stipulation of facts, with accompanying exhibits, is incorporated

herein by this reference.

     Petitioners, husband and wife, resided in Massachusetts at

the time they filed the petition.

     For 2004, they made a joint return of income on Form 1040,

U.S. Individual Income Tax Return, for that year.

Petitioner’s Real Estate Activities in General

     Petitioner husband (petitioner) is self-employed.    On a

Schedule C, Profit or Loss From Business, attached to their 2004

Form 1040, petitioner described his business as “carpentry/site

contracting”.   Over approximately the last 26 years, petitioner

bought and sold 16 parcels of real property.    Often, he would buy

unimproved land, build a single-family residence thereon, and

immediately sell the improved property.     Occasionally, he bought

and sold unimproved land.   Petitioner also bought unimproved land

and constructed multifamily housing thereon or bought land

improved with multifamily housing and improved the housing.

Petitioner did not immediately sell his multifamily housing

properties but kept them for rental income.
                                - 4 -

     Petitioner used brokers to assist in the sale of many of the

properties he sold.   He maintains a business office outside his

home but employs no staff at the office.

Petitioner’s Purchases and Sales of Multifamily Properties

     Petitioner purchased a five-family property on School Street

in Rockland, Massachusetts (Rockland), in 1983 and still owns it.

He acquired property on Myrtle Street in Rockland in 1984,

constructed a two-family rental unit thereon, and sold the

property in 1989.   He purchased property improved by a two-family

rental unit on Blanchard Street in Rockland in 1986 and sold it

in 1990.   He purchased rental property on Church and Howard

Streets in Rockland in 1987 and still owns it.     He purchased

property improved by a five-family rental unit on Oak Street in

Middleboro, Massachusetts, in 2006 and still owns it.

East Water Street Property

     In March 2004, petitioner purchased from his brother and

sister-in-law property on East Water Street in Rockland that had

been approved for subdivision into five lots.     After acquiring

the property, petitioner built a road on it, which was necessary

to access the five lots.   He conveyed to his brother one of the

lots, on which he constructed a house for his brother and his

family.    In November 2004, petitioner sold three of the remaining

lots (the three lots) for $750,000.     Petitioners reported the

gain from the sale of the three lots on Schedule D, Capital Gains
                                - 5 -

and Losses, to their 2004 Form 1040, claiming a basis of $376,159

and showing a short-term capital gain of $373,841.    Petitioner

sold the remaining lot in 2005 for $215,742.    Respondent

disallowed petitioners’ treatment of the gain from the sale of

the three lots as short-term capital gain and recharacterized the

transaction as a sale of property held for sale to customers in

the ordinary course of petitioner’s trade or business, which

respondent treated as a transaction reportable on the Schedule C.

Because of the resulting increase in petitioner’s Schedule C

income, respondent increased petitioner’s net earnings from self-

employment, which gave rise to a $16,104 increase in petitioner’s

self-employment tax (and an offsetting self-employment tax

deduction of $8,052).

     Petitioner testified that the three lots were “duplex lots”

(we assume lots appropriate for building duplex housing) and his

original intention was to keep those lots “to add to my investor

status but unfortunately the roadway cost me so * * * [much] I

had to sell those lots.    I had no choice.”

242 Beech Street Property

     In 1997, petitioner purchased a 34-acre industrial lot at

242 Beech Street in Rockland.    He testified that he had purchased

the property for investment and thought that he had paid $400,000

for it.   Thereafter, he obtained approval to subdivide the

property into 79 lots.    In 2006, he sold the property for $4
                                 - 6 -

million.   During 2004, petitioner kept heavy equipment related to

his carpentry/contracting business on the property.    Petitioner

did not rent the property to anyone during the time he owned it.

     On Schedule E, Supplemental Income and Loss, to their 2004

Form 1040, with respect to the property, petitioners claimed a

$99,956 deduction for:   (1) Legal and other professional fees of

$62,967, (2) mortgage interest of $26,860, and (3) real estate

taxes of $10,129 (together, the Schedule E expenses), all of

which respondent disallowed on the ground that the Schedule E

expenses did not relate to rental of the property.    Petitioner

actually paid the $62,967 claimed to be for legal and other

professional fees for engineering services attendant to surveying

and subdividing the property.

                                OPINION

I.   Gain From the Sale of the Three Lots

     We must determine whether the character of petitioner’s gain

from the sale of the three lots was capital gain (short-term

capital gain) or gain from the sale of property held primarily

for sale to customers in the ordinary course of his business.      If

the latter, the principal negative consequence to petitioner

appears to be an increase in his net earnings from self-

employment and the imposition of a self-employment tax (offset,

in part, by a self-employment tax deduction).
                               - 7 -

     In relevant part, section 1221(a)(1) excludes from the

definition of a capital asset “property held by the taxpayer

primarily for sale to customers in the ordinary course of his

trade or business”.

     Respondent argues that petitioner has a 20-year history of

buying real properties, improving them, and then selling them.

Respondent would include in that description the East Water

Street property, which included the three lots.   Respondent

states:   “Petitioner’s purpose in acquiring and holding the East

Water Street property was to sell the subdivided lots.”

Respondent argues that a consideration of the factors that courts

have recognized as helpful guides in determining whether a

taxpayer is holding property for sale in the business of buying,

developing, and selling property indicates just that with respect

to petitioner and the three lots.

     Petitioner concedes that he was a dealer in real properties

but argues that he was also an investor:

     The difference being delineated in [is] the variety in
     nature and extent of his various business interests.
     There is little long term investment profit in the
     single family rental business but the extent and
     duration of the Petitioner’s holdings of multi-family
     properties/inventory evidences the investment value of
     the multi family rental business.
                               - 8 -

He adds:   “The ‘multis’ were investment portfolio properties held

not to be sold in the ordinary course but to generate rental

income.”

     The parties agree that Mathews v. Commissioner, 315 F.2d 101

(6th Cir. 1963), affg. T.C. Memo. 1961-213, is representative of

the numerous cases distinguishing between property a taxpayer

holds for investment and property he holds primarily for sale to

customers in the ordinary course of his business.   In Mathews v.

Commissioner, supra at 106, the Court of Appeals stated:    “It is

true * * * that a taxpayer may hold lands primarily for sale to

customers in the ordinary course of his trade or business and, at

the same time, hold other lands for investment.”    It continued:

          It is well settled that the question whether
     property sold by a taxpayer at a profit was property
     held by the taxpayer primarily for sale to customers in
     the ordinary course of his trade or business, within
     the meaning of the statute, is essentially a question
     of fact. * * * No single factor or test is
     dispositive. Among the factors considered are: (1) the
     purpose for which the property was acquired; (2) the
     purpose for which it was held; (3) improvements and
     their extent, made to the property by taxpayer; (4)
     frequency, number and continuity of sales; (5) the
     extent and substantiality of the transactions; (6) the
     nature and extent of taxpayer’s business; (7) the
     extent of advertising to promote sales, or the lack of
     such advertising; and (8) listing of the property for
     sale directly or through brokers.

Id. at 107.

     Petitioner was a credible witness, and we accept his

testimony and find accordingly that he purchased the East Water

Street property for investment purposes, in part to build duplex
                               - 9 -

rental units on the three lots.   Petitioner also convinced us

that he purchased or constructed multifamily rental units not for

immediate sale to customers but, rather, as an investment, for

rental income and, we assume, appreciation.   Certainly, he did

sell two of the multifamily rental units, see supra p. 4, but

only after holding them for 4 or 5 years.   He has owned two other

of those units for over 20 years and the fifth for 4 years.

While petitioner did not detail for us the financial pressures

that caused him to conclude that he could not develop the three

lots as multifamily housing notwithstanding that he could sell

them at what appears to be a substantial profit, we are persuaded

that the three lots were intended for petitioner’s multifamily

rental activity and not his build-and-sell activity.   We

therefore find that petitioner did not hold the three lots

primarily for sale to customers in the ordinary course of his

business.   The lots were capital assets, and the resulting gain

was short-term capital gain.

II.   Schedule E Expenses

      Petitioner purchased 242 Beech Street in 1997.   He held the

property for 9 years and then sold it for a substantial profit.

During the interval, he incurred expenses for engineering

services attendant to surveying and subdividing the property, and
                               - 10 -

he obtained permission to subdivide it into 79 lots.    He kept

heavy equipment on a portion of the property.    He obtained no

rental income from it.

       Petitioner argues that the property was integral to his

business and that the Schedule E expenses incurred with respect

to the property for engineering services, interest, and taxes are

deductible under section 162 as ordinary and necessary business

expenses.

       Section 263A requires the capitalization of certain costs

(e.g., interest and taxes) that might otherwise be deductible.

Respondent argues that the Schedule E expenses must be

capitalized pursuant to section 263A because:    (1) They are

direct or indirect costs of the property and (2) the property is

property to which that section applies; viz, real property

“produced” by petitioner.2   See sec. 263A(a)(1)(B), (2), and (b)

(1).




       2
      At trial, on questioning by the Court, respondent’s counsel
conceded that the Schedule E expenses consisting of interest and
taxes would be deductible whether they were properly reportable
on Schedule E or on the Schedule C. Subsequently, counsel asked
to address on brief whether they should be deductible. We
agreed. In his brief, respondent argues that the interest and
taxes are capital expenditures and not immediately deductible.
Petitioner had the opportunity in his reply brief to address
respondent’s arguments with respect to the interest and taxes,
but chose not to do so. We shall, therefore, relieve respondent
of his concession.
                              - 11 -

     For purposes of section 263A, the term “produce” includes

“construct, build, install, manufacture, develop, or improve.”

Sec. 263A(g)(1).

     In pertinent part, section 1.263A-2(a)(3)(ii), Income Tax

Regs., provides:

     (ii) Pre-production costs. If property is held for
     future production, taxpayers must capitalize direct and
     indirect costs allocable to such property (e.g.,
     purchasing, storage, handling, and other costs), even
     though production has not begun. If property is not
     held for production, indirect costs incurred prior to
     the beginning of the production period must be
     allocated to the property and capitalized if, at the
     time the costs are incurred, it is reasonably likely
     that production will occur at some future date. Thus,
     for example, * * * a real estate developer must
     capitalize property taxes incurred with respect to
     property if, at the time the taxes are incurred, it is
     reasonably likely that the property will be
     subsequently developed.

     Among the indirect costs of property that must be

capitalized under section 263A are taxes, see sec. 1.263A-

1(e)(3)(ii)(L), Income Tax Regs., and engineering and design

costs, see sec. 1.263A-1(e)(3)(ii)(P), Income Tax Regs.

     Also, interest paid or incurred during the production period

of real property must be capitalized under the special rules of

section 263A(f).   Sec. 263A(f)(1)(A), (B)(i), (4)(A)(i); sec.

1.263A-12(a), Income Tax Regs. (in contrast to interest,

commencement of production period is not a threshold for

capitalization of other direct and indirect costs associated with

production).   The term “production period” means the period
                                - 12 -

beginning on the date on which production of the property begins

and ending on the date on which the property is ready to be

placed in service or is ready to be held for sale.     Sec.

263A(f)(4)(B).   The production period for real property begins

when any physical production activity begins.     See sec. 1.263A-

12(c)(2), (e), (f), Income Tax Regs.     Planning and design

activities, however, are not considered physical production

activities.   Sec. 1.263A-12(f)(1), Income Tax Regs.

     Petitioner testified that he purchased the property for

investment, but he did not further describe his investment

objectives.   We take from the fact that he did not rent the

property but prepared it for subdivision that his investment

objective was to subdivide the property and sell it.     While he

did keep heavy equipment on the property, we are unconvinced that

such use was other than incidental to his objective of developing

the property by subdividing it and then reselling it.     We

conclude that, during 2004, petitioner held the property for

production within the meaning of section 263A and the regulations

thereunder.   See sec. 263A(g)(1) (including as production

development and improvement).    We further conclude, however,

that, during 2004, no physical production activity on the

property had commenced.   Petitioner’s planning and design

activities did not constitute physical production.     See sec.

1.263A-12(f)(1), Income Tax Regs.    Nor, without more, do we
                             - 13 -

consider the storage of vehicles on the property a physical

production activity.

     Therefore, the Schedule E expenses of $62,967 and $10,129

for engineering services and real estate taxes, respectively,

must be capitalized; the mortgage interest expense of $26,860 is

not capitalized.


                                        Decision will be entered

                                   under Rule 155.
