                     112 T.C. No. 2



                 UNITED STATES TAX COURT



            JOHN J. REICHEL, Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No.   23143-97.           Filed January 7, 1999.



     P, a real estate developer, purchased properties
intending to develop them. He undertook no development
activities on the properties due to adverse economic
conditions. R disallowed P's deductions of the properties'
real estate taxes, determining the taxes must be capitalized
under sec. 263A, I.R.C., as indirect expenses of producing
property.
     Held: P must capitalize the tax payments under
sec. 263A, I.R.C.



Timothy W. Tuttle, for petitioner.

Michael H. Salama and Sherri S. Wilder, for respondent.
                                 - 2 -


                              OPINION


     LARO, Judge:   This case was submitted to the Court without

trial pursuant to Rule 122(a).    John J. Reichel petitioned the

Court to redetermine a 1993 income tax deficiency of $32,887 and

a $6,577 accuracy-related penalty under section 6662(a).

Respondent reflected this determination in a notice of deficiency

issued to petitioner on September 5, 1997.

     Following concessions by the parties, we must decide whether

section 263A requires petitioner to capitalize real estate taxes

he paid in 1993 on land he purchased for development.    We hold it

does.   Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the year in issue, and Rule

references are to the Tax Court Rules of Practice and Procedure.

Dollar amounts are rounded to the nearest dollar.

                            Background

     All facts have been stipulated and are so found.    The

stipulation of facts and the exhibits submitted therewith are

incorporated herein by this reference.    Petitioner lived in

Irvine, California, when he petitioned the Court.

     Petitioner has been a real estate developer since 1989.

In 1993, he operated his development business as a sole

proprietorship under the name Sunwest Enterprises (Sunwest).    He

reported Sunwest's income and expenses on Schedule C, Profit or

Loss From Business (Sole Proprietorship).
                                - 3 -


     Petitioner's business generally consists of buying and

developing raw land.    After purchasing a parcel of land,

petitioner applies for and obtains zoning variances, grading

plans, street plans, water plans, sewer plans, storm drain plans,

site plans, architectural plans, environmental feasibility

studies, and development and construction cost estimates.     He

then subdivides the land by having the city or county where the

land is located approve tentative tract maps, parcel maps, "ready

for recording" (but unrecorded) tract maps, and recorded tract

maps.   Once he has subdivided a parcel of land, he sells it to

homebuilders who build homes on it.

     In 1991, petitioner bought an undeveloped 8-acre parcel in

San Bernardino County, California, for $357,423.    One year later,

he bought a 10-acre San Bernardino parcel for $1,002,000.     (We

shall refer to these properties hereafter as the San Bernardino

parcels.)   Petitioner bought the San Bernardino parcels intending

to develop them.   He has never undertaken any of the development

activities described above in connection with the San Bernardino

parcels because he believes economic conditions in San Bernardino

County are adverse.    He continues to hold the parcels for

development.

     Petitioner paid $72,181 in real estate taxes on the San

Bernardino parcels in 1993.    He included these amounts in the

real estate taxes he deducted on his 1993 Schedule C.
                               - 4 -


                             Discussion

     Respondent disallowed petitioner's deduction for real estate

taxes on the San Bernardino parcels.      Respondent argues that

petitioner is a "producer" with respect to the San Bernardino

parcels under section 263A(g)(1), and, accordingly, that section

263A(a)(2)(B) requires petitioner to capitalize all real estate

taxes on this property.

     Petitioner argues that for 1993, section 263A(a)(2)(B) did

not require a taxpayer to capitalize real estate taxes until the

taxpayer took positive steps to begin producing the property.1

He states that because he took no steps to develop the San

Bernardino properties before or during 1993, he had not begun

production of the properties and was not required to capitalize

the taxes he paid on them.



     1
        There is no dispute that current regulations, if applied
according to their terms, would require that petitioner
capitalize the real estate taxes at issue. For post-1993 tax
years, sec. 1.263A-2(a)(3)(ii), Income Tax Regs. provides:

     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 manufacturer must
     capitalize the costs of storing and handling raw materials
     before the raw materials are committed to production. In
     addition, 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. [Emphasis added.]
                                    - 5 -


     We agree with respondent.       We start our analysis with the

relevant text, which reads as follows:

     SEC. 263A.    CAPITALIZATION AND INCLUSION IN INVENTORY
                   COSTS OF CERTAIN EXPENSES.

          (a) Nondeductibility of Certain Direct and Indirect
     Costs.--

               (1) In general.--In the case of any
          property to which this section applies, any
          costs described in paragraph (2)--

                       (A) in the case of property
                  which is inventory in the hands of
                  the taxpayer, shall be included in
                  inventory costs, and

                       (B) in the case of any other
                  property, shall be capitalized.

               (2) Allocable costs.--The costs
          described in this paragraph with respect to
          any property are--

                       (A) the direct costs of such
                  property, and

                       (B) such property's proper
                  share of those indirect costs
                  (including taxes) part or all of
                  which are allocable to such
                  property.

          *        *     *      *           *   *       *

          (b) Property to Which Section Applies.--Except as
     otherwise provided in this section, this section shall
     apply to--

               (1) Property produced by taxpayer.--Real
          or tangible personal property produced by the
          taxpayer.

          *        *     *      *           *   *       *

          (g) Production.--For purposes of this section--
                                - 6 -


                 (1) In general.--The term "produce"
            includes construct, build, install,
            manufacture, develop, or improve.

     Section 263A(a)(1)(B) requires that taxpayers capitalize

certain costs.    Section 263A(b)(1) provides that the

capitalization requirement applies to property "produced" by the

taxpayer.   Section 263A(g)(1) specifies that the term "produce"

means, among other things, "develop".    Thus, by its terms, the

statute requires taxpayers to capitalize indirect costs, such as

real estate taxes, that they incur in connection with property

they develop.

     Petitioner argues that the outcome in this instance is

controlled by our holding in Von-Lusk v. Commissioner, 104 T.C.

207 (1995).   The question in Von-Lusk was whether a partnership

had to capitalize costs incurred before it undertook any

activities that would physically alter certain land it was

developing.   The taxpayer had begun activities, such as

performing engineering and feasibility studies, similar to those

normally conducted by petitioner.    The taxpayer's parcels of

land, coincidentally, were located in San Bernardino County.

We held that activities such as these were development activities

even though they had no immediate physical impact on the property

and that a taxpayer who undertakes them has begun producing the

property.   Id.

     Petitioner argues that Von-Lusk established the principle

that some such activity must have taken place for production of

the property to have begun.    Since he has never undertaken any
                               - 7 -


such activities with respect to the San Bernardino parcels,

petitioner states, he has never begun producing them within the

meaning of section 263A, and therefore he need not capitalize the

real estate taxes.

     We disagree with petitioner's reading of Von-Lusk v.

Commissioner, supra.   We did not decide in Von-Lusk whether

capitalization is required for expenses incurred before

production begins.   We decided principally that the taxpayer had

already begun development of the land in question and had to

capitalize related development costs even though the land had not

yet been physically changed.   In deciding Von-Lusk, we reviewed

the text and legislative   history of section 263A and observed

that the Congress intended the term "produce" to be broadly

construed.   We noted that "Congress expected those rules to be

applied from the acquisition of property, through the time of

production, until the time of disposition."     Von-Lusk v.

Commissioner, supra at 215 (emphasis added).2

     A close analysis of the language and structure of section

263A supports the conclusion that Congress intended that the

capitalization rules cover costs incurred before as well as

     2
       Petitioner also relies on Hustead v. Commissioner, T.C.
Memo. 1994-374, affd. without published opinion 61 F.3d 895
(3d Cir. 1995). In Hustead, we indicated that taxpayers who
increased the value of their land by challenging a local zoning
ordinance had not begun producing the land within the meaning of
sec. 263A(g). We held, however, that the legal costs the
taxpayers incurred in challenging the ordinance had to be
capitalized under sec. 263. Since sec. 263 controlled the result
in Hustead, we were not required to decide whether sec. 263A
would apply to the taxpayer.
                                - 8 -


during the production period.    This is evident when we examine

section 263A(f), which provides a narrow exception under which a

particular category of indirect production costs, namely

interest, does not have to be capitalized until the production

period begins.    There would be no need for this exception if

capitalization were never meant to apply until taxpayers actually

started the production process.    As we noted in Von-Lusk v.

Commissioner, supra at 213 (quoting Weinberger v. Hynson,

Westcott & Dunning, Inc., 412 U.S. 609, 633 (1973)):

     if no costs were to be capitalized until the beginning
     of the "production period," then section 263A(f)(1)(A)
     would be superfluous. Such a construction "offends the
     well-settled rule of statutory construction that all
     parts of a statute, if at all possible, are to be given
     effect."

     The legislative history of section 263A also supports this

reading.    In describing the reasons for enacting section 263A,

the relevant section of the House report is headed,

"Preproduction costs" and states the concern that then-existing

rules "may allow costs that are, in fact, costs of producing

property to be deducted currently".     H. Rept. 99-426, at 625

(1985), 1986-3 C.B. (Vol. 2) 1, 625.     While headings are not

compelling evidence of meaning in themselves, the corresponding

section of the Senate report clarifies and reenforces this

analysis.    That section is headed "Production, acquisition, and

carrying costs" (emphasis added) and expresses the intent that "a

single, comprehensive set of rules should govern the

capitalization of costs of producing, acquiring, and holding
                                - 9 -


property"(emphasis added).   S. Rept. 99-313, at 140 (1986), 1986-

3 C.B. (Vol. 3) 1, 140.

     In sum, petitioner has conceded that although development of

the San Bernardino parcels was deferred by adverse economic

conditions, he acquired and held those parcels intending to

develop (i.e., produce) them.   Because the real estate taxes at

issue are expenses petitioner incurred that are allocable to

those properties, he must capitalize those expenses under section

263A.

     In reaching our conclusion herein, we have considered all

arguments made by petitioner for a contrary result, and, to the

extent not mentioned above, find them to be irrelevant or without

merit.   To reflect respondent's concessions,

                                             Decision will be entered

                                        under Rule 155.
