The U.S. real estate market has always attracted the attention of investors and developers worldwide and even more so recently because of a number of factors including increased financing channels (such as crowdfunding), more opportunities for foreign investors through special programs (such as the EB-5 program), and instability in emerging foreign markets. Properly planning for a real estate transaction is imperative to lowering tax expenses and increasing returns for investors. To plan effectively, however, many factors warrant consideration—e.g., intent, structuring, and ownership of an entity—a proper combination of which will provide the best opportunity for success.
The owner's intent for the property determines the character of gain that will be recognized when it is sold. The gain could be taxed at ordinary or capital gain tax rates. A gain on the sale of property held primarily for sale to customers in the ordinary course of business is subject to ordinary gain treatment. In this case, the term "primarily" means "of first importance" or "principally." Increased tax rates on ordinary income in recent years have made it more critical to plan a transaction properly to obtain capital gain treatment on a sale.
Upon the sale of a capital asset held for more than 12 months, the gain generally qualifies to be taxed at the preferential long-term capital gain rate. A capital asset, as defined by Sec. 1221(a), is "property held by the taxpayer (whether or not connected with his trade or business)" but, as clarified by Sec. 1221(a)(1), it does not include property held by the taxpayer primarily for sale to customers in the ordinary course of his or her trade or business.
Determining the Type of Asset Sold
Often, the distinction between a capital asset and an asset sold in the regular course of business is ambiguous. The determination is made based on the facts for a particular asset. The Tax Court analyzes several factors, including the following, to determine whether property is a capital asset or an asset held primarily for sale to customers in the ordinary course of business:
1. The nature and purpose for which the asset was initially acquired and the duration of ownership;
2. The purpose for which the property was subsequently held;
3. The extent to which the taxpayermade any improvements to theproperty;
4. The number, extent, continuity, and substantiality of the sales;
5. The extent and nature of the transactions involved;
6. The taxpayer's ordinary business;
7. Use of the property as a businessoffice;
8. The extent of advertising for sale of the property;
9. Listing the property with brokers;
10. The purpose for which the property was held at the time of the sale.
In a recent case, Fargo, T.C. Memo. 2015-96, a partnership was disallowed capital gain treatment on income received from the sale of property to an unrelated entity because the overall facts indicated the property was purchased and held primarily for development and sale to customers in its ordinary course of business, instead of for investment. The partnership never took substantial actions to improve the property, never made a significant effort to solicit potential buyers or list the property for sale with a broker, never engaged in extensive marketing activities, never had sold real estate before this sale, and had used the property as office and rental space.
Despite the fact that the partnership's activities appeared similar to those of an investment company, after analyzing the factors mentioned above, the Tax Court concluded the property was not a rental property because the entity's primary intent was to develop the land, and renting part of it was just "making its best use of the . . . property as office and rental space." The court also found the partnership had incurred significant development expenses. Thus, the court imposed ordinary income tax rates on the gain.
Tax Planning Opportunity
A tactic to better ensure capital gain treatment may be implemented to avoid an outcome such as the one in Fargo, so at least part of the gain is treated as a capital gain. While this tactic is not a new concept, it should be kept in mind as the real estate market continues to improve and the possibility of large gains increases.
To receive capital gain treatment on the sale of an asset, establishing a set of facts to show that a particular property was held for investment is important and should begin before the asset is acquired.
One tactic that can safeguard capital gain treatment is to divide the classification of the gain on sale of property into capital and ordinary gain treatment. It allows any appreciation accrued before the property became held "primarily for sale to customers" to be taxed at the capital gain rates. This strategy calls for separate ownership of property held for investment and for property held primarily for sale to customers. While the Tax Court indicated an identical ownership structure of both entities is acceptable and will not bar capital gain treatment, some variation to the ownership structure is suggested to emphasize the entities are in fact separate. Before any development activities occur, the investment company should sell the property to the development company at fair market value. Any gain from this sale will be taxed at the capital gain rate since the sale occurred before significant development activities began.
To successfully safeguard capital gain treatment, the following should be considered:
1. The longer the property is held from its acquisition until its transfer to the development company, the greater the likelihood of capital gain treatment (of course, the property must be held for a year to qualify for long-term capital gain treatment).
2. Organizational documents of the investment company should indicate the company was established as an investment company. The company should consistently refer to itself as an investment company on all documents, including tax filings. The investment company should not refer to the development company in any documents, even if they are only for internal use.
3. During the time the investment company owns the property, all activities that would indicate the company intends to develop the property must be avoided. Even improvements to the property can increase the risk that the Tax Court may view the investment company as having held the property primarily for sale to customers instead of for investment.
4. Each entity must have a legitimate business purpose. The Tax Court found in Phelan, T.C. Memo. 2004-206, and Pool, T.C. Memo. 2014-3, that protecting the investment company's assets from liabilities and risks related to developing property for sale to customers is a legitimate business purpose.
5. All terms of the sale must be at arm's length. This means the purchase price of the asset must be at fair market value and the asset must be appraised.
6. Do not create an agency relationship between the investment and development companies. Separate books and records should be maintained, as well as separate bank accounts and separate minutes of management meetings, and the entities should not enter into any agreements together. Also, keep transactions between the two entities to a minimum.
7. Avoid Sec. 707(b)(2) ordinary gain treatment, which is triggered when property other than a capital asset is transferred between a partnership and a person owning directly or indirectly more than 50% of the capital or profits interest in the partnership. Ordinary gain treatment will also occur if the transfer is between two partnerships in which the same person owns, directly or indirectly, more than 50% of the capital or profits interest. One way to avoid this is to establish one of the entities as a corporation (either a C corporation or an S corporation).
8. The investment company should minimize the number of times it sells real estate so it is not viewed as a development company. The investment company should also not participate in any development or marketing activities relating to real estate. These activities should be undertaken by the development company once the land is transferred. The investment company should avoid any activities that could give the appearance it is holding the property primarily for sale to customers.
9. If the investment company is projecting losses in the future, consider whether capital gain treatment in the current year will prohibit the deduction of losses against ordinary income later on.
It takes a tremendous amount of preparation and planning to successfully implement a capital gain safeguarding tactic. Since there are many components to consider, an entity should plan a real estate transaction properly so its cash flow is not wasted on avoidable taxes. If the taxpayer in the Fargo case had implemented a strategy to safeguard its capital gain treatment, at least part of the gain on the sale would have had a better chance of being considered capital. Thus, carefully planning and structuring an entity before acquiring real estate is key so, if the situation arises, the entity can prove it is an investment company and receive the benefit of the lower capital gain rates.
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.