John J. Reichel v. Commissioner ( 1999 )

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.
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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).
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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.
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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.]
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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--
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(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
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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.
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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
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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.