When it comes to unraveling real estate wheeling-dealing, there’s nobody like The Great Dissenter, a/k/a The Judge Who Writes Like a Human Being, His Honor Mark V. Holmes. In support of the foregoing, I make an offer of proof in my blogposts “Basis for Dummies”, 11/24/11 and “The Sum of Its Parts”, 3/12/12.
And His Honor is on his game with Stephen M. Gaggero, 2012 T. C. Memo. 331, filed 11/29/12.
Steve thought his name was Blanchard from his earliest youth, until he met his natural father and became Gaggero. Though a high-school dropout, he taught himself carpentry, worked for film studios, bought and rehabbed real estate, and memorialized his youthful name in his wholly owned C Corp, Blanchard Construction Company (BCC). He employed 40 people at one point, but when the facts in this case came to a head, he was down to a dozen or so, including in-house counsel, designers, decorators and laborers. But high on Steve’s faves list was his trusty CPA, Jimbo Walters.
Steve was a success story. He bought a tumble-down shack in Malibu during one of California’s periodic real estate crashes, and made a deal with BCC: BCC will rehab the place and Steve will live there as his primary residence. “BCC redesigned, rebuilt, and expanded the house and grounds–adding amenities such as a small golf course, stadium tennis court, new pool and secret pathway that wound from the home through the woods to a private beach–and Gaggero personally paid approximately $1.5 million for the cost of these improvements.” 2012 T. C. Memo. 331, at p. 4. (Footnote omitted.)
In exchange for completing the rehab, if the house was ever sold, BCC would get half the gain over a stipulated $3 million value at contract signing. And there was a contract. And BCC did complete the work.
But the house wasn’t sold for six years. And when it was sold, to a Belgian biochemist after a contentious negotiation, it fetched $9.6 million. Steve never told the Belgian about his deal with BCC, but did file some papers later showing BCC’s involvement. He also paid BCC $3 million, which BCC reported as ordinary income.
Steve took whatever gain he had made on what he claimed was his piece of the deal and rolled it over under old Section 1034, whose effect ceased a few months after Steve’s mansion got sold. But the new house he bought within the two-year timeframe of old Section 1034 cost about $3 million less than the sales price of the mansion BCC built. Steve claimed he only got what the new house cost, and BCC got the rest.
IRS says no. IRS claims BCC was just a contractor with nothing more than a mechanics’ lien. No, says Judge Holmes. This was a real land sale contract. BCC did have equitable title and could have sued Steve. And the contract contemplated that Steve might sell BCC at some future point; while Steve could call the shots during development and rehab, if Steve sold BCC, all decisions would have to be unanimous between Steve and any future owner of BCC. The Belgian biochemist was a tough customer, the broker was trying to sabotage the deal, so Steve was justified in keeping quiet about BCC’s involvement.
“On completion of its development work, BCC had a share of the benefits and burdens in the property and received part-ownership in the property. We accept Gaggero’s explanation that disclosure of BCC’s interest to [the Belgian] would have jeopardized the sale of the property, but note that both Gaggero and BCC filed separate real-estate reporting solicitation forms to the escrow agent, showing that there were multiple transferors. Both Gaggero and BCC were paid directly from the escrow for their respective ownership interests. And the $9.6 million sale proceeds was allocated according to the Sale Agreement–$6.6 million to Gaggero, and $3 million to BCC.” 2012 T. C. Memo. 331, at p. 27.
So Steve’s sale to BCC is real. But Steve never reported the capital gain on his sale to BCC. And BCC only reported ordinary income on the $3 million it got (a corporation couldn’t use Section 1034).
So Judge Holmes carefully crafts a table, and calculates percentages wherewith to fill in the blanks (which see, at pp. 36-50; yes, it’s long, and yes, it’s prosy, but it’s vintage Holmes).
And Steve owes capital gains tax on his sale to BCC, which he can’t bury in the new house because he already used his share.
Now as to penalties, to wit, substantial understatement, as Steve never mentioned $3 million in gain. Steve claims he relied on Jimbo. Judge Holmes looks to the usual three-part test, competence of expert, information given expert and actual good faith reliance. IRS claims Steve didn’t rely in good faith, because he knew as much as his lawyer at the trial, suggesting questions, overruling his attorney’s advice, manifesting a deep understanding of tax law. Just the sort of client an adviser should love.
So IRS argues “the deal is too good to be true, and Sophisticated Stevie should have known it.” Moreover, IRS claims Steve may have carefully crafted his erroneous return so as to plead ignorance if caught.
Judge Holmes isn’t buying. Steve did the BCC deal six years before he sold the house. It had economic substance, Jimbo was with a big-ticket CPA firm and had substantial real estate and tax creds, and Steve was a credible witness.
So Steve must pay capital gains on his sale to BCC, but no penalty.
And again, Holmes fans, this is the real deal.