Although it may come as a surprise to many, it is no secret that South Florida property values are on the rise. Over the past few years, wealthy Latin Americans and other foreign investors have turned their investment focus to the depressed real estate market in South Florida. Once a market that was flooded with thousands of unsold condominium units, South Florida is now running low on inventory and there are at least 80 announced plans for new residential projects in South Florida.
Increased Demand for Land
With the increased demand for new residential projects comes an increased demand for the underlying land on which the projects can be built. Many land owners who weathered the storm during the recent economic crisis and those who were able to acquire land at depressed values may now be able to reap the benefits of this recent boom of development activity.
Unique Tax Opportunity for Certain Property Owners
What should not come as a surprise to anyone, however, is the increase in federal income tax rates that took effect on January 1, 2013. With the increased rates for ordinary income (i.e., 39.6%) and capital gains (i.e., 20%), and the imposition of new taxes on certain investment income, proper tax planning is as important as ever. The spike in real estate values and residential development activity presents a unique opportunity for certain property owners in South Florida to capture the appreciation in their real estate holdings as long-term capital gains before any development activity begins on the property.
In most circumstances, the treatment of gain from the sale of real property will depend on the seller’s status as either a “dealer” or an “investor”. Gain or loss on property held for sale by a dealer is generally treated as ordinary income, whereas sales of capital assets that are held for investment purposes generally receive capital gain treatment. If sales by a taxpayer are frequent or substantial, if the property has been improved too much by the seller, or if the buyer is merely an agent of the seller, then the IRS will often attempt to deny capital gains treatment.
Tax Planning Technique to Obtain Capital Gains Treatment Pre-development
Many land developers use partnerships or limited liability companies to buy and hold property for investment while planning the development of the property. One tax planning technique that is often used is for the partnership (or LLC) to sell the property to a related corporation before physical development of the property is ready to commence. The concept behind this technique is to obtain capital gains treatment for the appreciation inherent in the land pre-development, followed by ordinary income treatment on the property development and ultimate sale to outside parties.
For property owners seeking to participate in the development of the property, the choice of entity used to acquire the property from the partnership before development is important. A property owner that holds land for investment as a capital asset ordinarily will recognize capital gain on the sale of such property to a third party. However, current tax laws provide certain rules that recharacterize such gain as ordinary income when the sale is between related partnerships. Therefore, when structuring the sale of property between related entities, it is often important to structure the purchasing development entity as a corporation for federal income tax purposes. In addition, it is also important that the activities of the investment entity and the development entity remain separate so that the development activities do not taint the characterization of the land as held for investment in the hands of the investment entity.
Despite the economic crisis of recent years, many South Florida land owners recognize the unique opportunities presented by the current spike in development activity and are planning ahead with their advisors accordingly.