Real estate professionals regularly employ a strategy of holding or owning some real estate for investment and some as a dealer. Holding property for investment has several advantages, including being able to report the gain from the sale of investment property as capital gain, which is subject to a substantially lower tax rate than income from the sale of dealer property. In employing that strategy, one must be careful that the treatment of investment property is not mixed too closely with the dealer side of the taxpayer’s business, or the benefits of investment strategy might be lost (resulting in significant additional taxes being payable).
This topic is addressed in detail in an article that I co-authored and presented with Steve Looney in 2008 at the NYU Institute of Federal Taxation entitled “Dealer vs. Investor: Maximizing Capital Gains,” which provides a detailed review of the case law in that area. Under that body of law, the courts have adopted a facts and circumstances analysis to determine whether a taxpayer is holding property as a dealer or investor. Sales by a dealer results in the gain on such sales being treated as ordinary income, gain on sales by an investor can result in gains being treated a capital gains.
We often work with real estate professionals to assist them in carefully planning for their ownership of property in an effort to minimize the tax liability produced from sale of property. A “land banking” approach can be used to bifurcate gain recognized on the sale and later development of property. A properly conceived land-banking arrangement will allow an investor in real estate to purchase and hold investment property for a period of time, allowing the property to appreciate. That appreciation is then recognized as long-term capital gains (subject to lower income tax rates) in a sale of the property to a related but different entity in an arms-length transaction. The purchasing entity then develops and later sells the property, then as dealer property, resulting in ordinary income. The NYU article discusses the case law under which the courts have identified the factors to be considered in determining whether property is being held by a taxpayer as an investor or as a dealer.
While many taxpayers are successful in walking through the minefield of this area of the law, the Tax Court recently issued an opinion in Pool v. Commissioner, T.C. Memo 2014-3 (issued in January 2014) that shows that improper planning in the area can lead to a bad result: that is ordinary income treatment on the gain recognized on the sale of property from a taxpayer (purportedly a land banking type entity) to a related development entity. The Pool facts are not too different from what we normally see in these types of arrangements. The taxpayer in Pool organized an LLC taxed as a partnership, Concinnity, LLC. The same taxpayers also organized a corporation, Elk Grove Development Company (Development). Concinnity purchased 300 undeveloped acres near Bozeman, Montana at a time when such property was already divided into 4 sections or phases, which later became a PUD. Concinnity entered into an agreement with Development under which Development was given the exclusive right to purchase phases 1-3 of the PUD and which required Development to complete all infrastructure improvements needed to obtain the final plats on each phase of the PUD. Concinnity also entered into an “improvements agreement” with the county agreeing that it, as subdivider, would pay for the improvements of the land in phase 1. Other facts in the case informed of the coordination of the ownership and development of the property by both Concinnity and Development and seemed to reflect a non-arm’s length relationship between the two parties.
While Concinnity reported the gain from the sale of phase 1 as ordinary income, it reported the gain on the sale of phases 2 and 3 as long-term capital gains. Under audit, the IRS claimed that all the gain recognized by Concinnity for all three phases of the PUD resulted in ordinary income and the Tax Court, using a facts and circumstances analysis, agreed.
In cases like Pool, the taxpayer normally has the burden of proof to show that the taxpayer is not a dealer with respect to the subject property. In Pool the taxpayer was not successful in proving to the Tax Court that Concinnity held phases 2 and 3 as an investor. In finding against the taxpayer, the court focused on the nature of the acquisition, the frequency and continuity of sales, the nature and extent of Concinnity’s business, the activity of Concinnity about the property and the extent and substantiality of the sales transactions and whether the transactions between Concinnity and Development were made at arm’s length.
While this adverse case may show “how not to” do this type of capital gain planning, it illustrates the importance that planning and structuring can have in this day of high ordinary income rates and significantly lower long-term capital gain rates.
Borrowing from a famous Mel Brooks line from Blazing Saddles: “It is good to be an investor!”