Gains & Losses
When land is sold, it is often assumed that long-term capital gain rates apply to the transaction. While these rates may apply to the majority of sales, recent decisions from the Tax Court and a U.S. district court in California are reminders that land may not always be a capital asset that gives rise to a capital gain when sold. Land may also be held for sale to customers in the ordinary course of business, in which case gain on the sale of the land will be ordinary income. Both decisions use a standard, five-factor test that has been developed in case law to determine which category the land in question falls into. These factors focus not only on the circumstances leading up to the sale but also the seller's intent during the acquisition of the property. Using them, the court is required to:
- Analyze the nature of the acquisition. Was the land initially purchased for investment or development? At that time, was the taxpayer's primary service and/or principal product real estate?
- Assess the frequency and continuity of the taxpayer's property sales. Is the taxpayer often involved in land sales, indicating that the land is more like inventory than an investment?
- Consider the nature and extent of the taxpayer's business. Were the taxpayer's actions to increase the land's value more like those of a developer or an investor?
- Examine the level of the seller's involvement when selling the property. Did the taxpayer spend a significant amount of time finding buyers and negotiating property sales?
- Evaluate the extent and substantiality of the sale transaction. Were there any red flags indicating that (1) the sale may not have been at arm's length or (2) the price may not have been at market value?
In a recent case, Pool,T.C. Memo. 2014-3, the Tax Court considered these five factors in ruling that the taxpayers improperly reported ordinary partnership income as capital gain. The case involved a limited liability company, Concinnity LLC, which purchased 300 acres of undeveloped land divided into four sections. Three of the sections were part of an exclusive rights agreement with a development company, and the LLC eventually sold these sections to the development company in two installment sales. On Concinnity's 2005 return, the LLC reported the taxable portion of the payments received in 2005 from these sales as a long-term capital gain. The IRS audited the partnership and disallowed capital gain treatment, concluding that Concinnity was a dealer in real estate.
The Tax Court examined the five factors and came to the following conclusions: (1) Concinnity purchased the land to divide and sell to customers; (2) Concinnity failed to prove that its sales of land were not frequent enough to be considered to be in the ordinary course of business; (3) Concinnity took more of a developer's role than an investor's role because the company improved the land with water and wastewater systems, found additional investors, and brokered the land sale deals; (4) there was little proof that Concinnity did not actively seek out buyers for individual lots before it sold the three sections of land to the development company; and (5) the sale to the development company was at a price well above market value and thus was not at arm's length. As a result of these findings, the Tax Court denied Concinnity's partners' capital gain treatment on the sale of the property.
In another recent court decision, Allen, No. 13-cv-02501-WHO (N.D. Cal. 5/28/14), the U.S. District Court for the Northern District of California determined that three of the five factors in the case proved the property sale in question was more similar to a sale to a customer in the ordinary course of business than to a sale of a capital asset.
In the late 1980s, Fredric and Phyllis Allen purchased several acres of land to develop and sell in East Palo Alto, Calif. After attempting to develop the property themselves, which included hiring engineers for planning purposes, the Allens changed their focus and instead tried to find investors to develop and sell the property. In 1999, the property was sold to a real estate development corporation under an installment sale arrangement. On their 2004 Form 1040, U.S. Individual Income Tax Return, the Allens reported the final installment payment of $63,662 as a long-term capital gain.
The IRS denied the long-term capital gain treatment, arguing that the Allens held the property for resale and not as investment property. The court sided with the IRS. It found that the first and fourth factors were determinative, stating that Allen held the property for resale because "the evidence is compelling that Fredric Allen intended to develop the Property when he purchased it and that he undertook substantial efforts to develop it during the time that he owned it." The court also considered the other factors, but found that the support they gave for the Allens' position was not strong enough to change its conclusion based on the first and fourth factors.
Steps to Take
Because courts will generally use the five-factor test, taxpayers can plan how they structure, undertake, and account for a land sale to reduce the chance that a court will hold that it was not a sale of investment property. Based on these factors, taxpayers can take the following steps to avoid this result:
Segregate property in the books and records: The segregation of books supports a taxpayer's intent to hold a piece of property while also increasing the chances of capital gain treatment when the taxpayer sells the investment property.
Report items as investment expense: Deductions related to a piece of property, such as interest expense, should be reported as investment expenses. Classifying these expenses as business expenses provides an indication that the taxpayer held the property for sale in the ordinary course of business.
Stating investment purpose in governing documents: If an investor is a partnership, LLC, or corporation, the entity's governing documents should state that the entity's sole purpose is investment activities. The meeting minutes of the entity should also express this intent.
Using separate entities: One factor that determines a seller's intent is the frequency of sales (factor 2). To avoid dealer status, it may be advantageous to hold investment property in a separate legal entity with a different ownership structure.
Insubstantial nature of the real estate activity: Taxpayers who can show that the time spent in investment activities is insignificant when compared with the time spent in their everyday occupation may be able to achieve investor status.
Considering the gap between long-term capital gain tax rates and the highest ordinary income tax rates, the services CPAs can provide become more important to clients. While it may be beneficial to achieve dealer status if a taxpayer has net operating losses, it is often more beneficial for taxpayers that are not in the real estate business to attain investor status and the preferential tax rates associated with that status. By properly structuring real estate transactions and appropriately setting up records and books, taxpayers have the opportunity to establish dealer or investor status to achieve the desired tax treatment.
Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.