Sale of improved land: Capital or ordinary gain?

Editor: Mark Heroux, J.D.

When real property is subdivided into lots and actively sold, the common result is that the gain on sale of the property is subject to ordinary income tax treatment. However, this may not always be the case under Sec. 1237. In certain situations, a taxpayer still may be able to claim capital gain treatment under the five- or 10-year rule, even if the taxpayer subdivides the real property into lots and actively tries to sell the parcels.

Five-year rule

To take advantage of this exception, the taxpayer must meet the following conditions (Sec. 1237(a)):

• No portion of the tract has ever been held for sale in the ordinary course of the taxpayer’s business;
• No other real estate was held for sale to customers in the year of sale;
• No substantial improvements have been made on the tract that materially increased the value of the lot sold; and
• The property must have been owned by the taxpayer for five years, unless the taxpayer inherited it.

Most often, taxpayers do not qualify for capital gain treatment under the five-year rule because they do not meet the substantial improvement requirement. Substantial improvements include “installation of hard surface roads or utilities such as sewers, water, gas, or electric lines” (Regs. Sec. 1.1237-1(c)(4)).

10-year rule

Under the 10-year rule, a taxpayer can still receive capital gain treatment even though improvements were made to the land. Under certain circumstances, a taxpayer can elect to have substantial improvements treated as necessary and not substantial if all of the following conditions are met (Sec. 1237(b)(3) and Regs. Sec. 1.1237-1(c)(5)(i)):

• The taxpayer held the property for 10 years;
• The improvements consist of the installation of water, sewer, or drainage facilities, or roads, including hard-surface roads, curbs, and gutters;
• The IRS is satisfied that the improvements were necessary and that without the improvements the lot’s fair market value would be less than the prevailing price for similar building sites; and
• The taxpayer elects not to adjust the basis of the lot sold for the cost of those improvements as well as not to deduct any part of the cost as an expense.

Determining whether to make the election

At first glance, it may not seem beneficial to make the election to treat the improvements as not substantial since the taxpayer cannot include the cost of these improvements in the basis of the asset and cannot deduct the correlating cost as an expense. However, there may be a significant tax benefit to making this election in some circumstances:

• The taxpayer anticipates a sizable gain on the sale and also has a substantial capital loss (including carryovers) to minimize the potential tax liability on the capital gain; or
• There is a considerable difference in the taxpayer’s marginal tax rates for ordinary income and capital gains, and the improvements are relatively low-cost compared with the lot’s value.

Additional opportunities on making the election

Even if the property is subdivided and the parcels are sold off incrementally, Sec. 1237 allows a taxpayer holding unimproved property to maintain investor status and for the property not to be treated as held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. Under this fact pattern, a couple of additional opportunities are available:

• The taxpayer can report the income using installment sale treatment under Sec. 453 since this provision applies to capital gain and not ordinary income inherent to real estate dealers. Under the installment sale treatment, the taxpayer can defer gain until installment payments are received; or
• The taxpayer can defer the gain under the like-kind exchange provisions of Sec. 1031 since it also does not apply to property that is considered inventory but instead to property that is deemed an investment (or held for productive use in a trade or business).

Rogers

In a recent Tax Court case, Rogers, T.C. Memo. 2018-53, the taxpayer argued that land transferred as a capital contribution to his business and then subsequently sold in subdivided lots should be taxed as capital gain income under Sec. 1237. While the court refused to address the issue because the taxpayer did not properly raise it, the court indicated it did not agree that Sec. 1237 would apply, because the taxpayer originally reported the revenues from the sale of lots as ordinary income and, contrary to the rules of Sec. 1237, included the costs of improvements in the basis of the lots. As the case suggests, the decision to apply Sec. 1237 on the sale of lots should be made before any lots are sold.

Overall, Sec. 1237 provides a tax planning opportunity, and if the appropriate conditions are met, it can generate substantial tax savings.

EditorNotes

Mark Heroux, J.D., is a principal with the National 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 mark.heroux@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.