Structuring Real Estate Investments for Later Development: Maximizing Long-term Capital Gains

• Publication year: 2004
• Pages: 129

33 Colo.Law. 11 Colorado Lawyer 2004.

2004, August, Pg. 129. Structuring Real Estate Investments For Later Development: Maximizing Long-Term Capital Gains

Vol. 33, No. 8, Pg. 11

The Colorado Lawyer
August 2004
Vol. 33, No. 8 [Page 129]

Specialty Law Columns
Real Estate Law Newsletter
Structuring Real Estate Investments For Later Development Maximizing Long-Term Capital Gains
by Brent W. Houston

This column is sponsored by the CBA Real Estate Law Section.
Articles in this column cover a broad range of real estate land use, and related topics, and focus on the practical aspects of matters of interest to real estate lawyers

Column Editors:

Steve Sommers, Denver, Brownstein Hyatt & Farber PC - (303) 223-1100,
ssommers@bhf-law.com; Pat Barney, Steamboat Springs, TIC - (970) 879-2561, barneyp@ticus.com

Brent W. Houston
About The Author:

This month's article was written by Brent W. Houston, Greenwood Village, an attorney with Benjamin, Bain & Howard, LLC - (303) 290-6600, bhouston@bbhlegal.com. The author thanks John Birkeland, Denver, an attorney with Sherman & Howard, LLC, for his help with this article.

This article discusses a method by which an investor in real estate who decides to develop the property can preserve capital gain treatment for pre-development appreciation of the property.

The maximum long-term capital gain tax rate applicable to non-corporate taxpayers was reduced from 20 percent to 15 percent as a result of the "Jobs and Growth Tax Relief Reconciliation Act of 2003."1 That act also reduced the maximum marginal ordinary income tax rate applicable to non-corporate taxpayers from 38.5 percent to 35 percent. These rate reductions have piqued the interest of real estate investors and developers in preserving long-term capital gain treatment for the appreciation of real estate accruing prior to development of the property.

Generally, if a person or entity acquires a parcel of land, constructs commercial buildings or residential units on the property, and then sells the developed property, the entire appreciation of the property from time of purchase to time of sale will be subject to tax at ordinary income tax rates. This ordinary income tax treatment applies without regard to the length of time between acquisition and sale of the property. Often, individuals or families acquire land for investment and hold it for many years before deciding to develop the property. Such land may have appreciated significantly in value prior to any development.

This article describes a method for the landowner to separate the profits attributable to the passage of time prior to development from the profits attributable to development efforts. By this method, the landowner may preserve the desired capital gain treatment for pre-development appreciation. This article also discusses pre-development planning techniques for preserving capital gain treatment.

Pre-Development
Planning

With careful planning, a landowner may preserve capital gain treatment for any pre-development appreciation, even though the property is sold following development. This is accomplished by acquiring the land in one entity and developing it in another entity. Such tax treatment is usually accomplished by acquiring the land via a pass-through entity taxed as a partnership, typically a limited liability company ("LLC"), that has the sole purpose of holding the real estate for investment (hereafter, "Investor LLC"). Nevertheless, despite the widespread use of LLCs for this purpose, the investor entity is not required to be an LLC or other entity taxed as a partnership.2 If the land is already owned by an entity taxed as an "S" or "C" corporation, this planning technique will work, provided the developer entity is an LLC or other entity taxed as a partnership.

After holding the land for at least one year, the Investor LLC sells the property in an arm's length transaction to another entity, typically an "S" corporation3 (hereafter, "Developer Corp.") that is owned by some or all of the members of the Investor LLC. Thereafter, the Developer Corp. develops and sells the improved property.

This pre-development sale technique, if implemented properly, will provide the owners of the Investor LLC with capital gain treatment for any pre-development appreciation. It also will give Investor LLC owners the ability to share in the profits from the sale of the developed property through their ownership interests in the Developer Corp., which profits will be subject to tax at non-corporate ordinary income tax rates.

The benefit of preserving capital gain treatment for pre-development appreciation can be significant. For example, assume that an LLC, which has elected to be taxed as a partnership, is owned by two individual members. The LLC owns raw land with a tax basis of $250,000, which it has held for ten years. The fair market value of the property has increased to $1.25 million. The LLC members desire to develop the property into single-family residences and expect to incur expenses of $750,000 to develop the property. Such expenditures will result in a tax basis of $1 million on completion of the development.

Revenues from the sale of the residences are estimated at netting $4 million. If the LLC acquires the property and develops it, the sale of the homes will yield $3 million of ordinary income to the LLC, which will be passed through to its members. However, selling the property prior to development for its fair market value of $1.25 million to a corporation that is controlled by the members of the LLC will convert $1 million of the $3 million ordinary income into long-term capital gain, if such a transaction is respected for tax purposes, as discussed below. Assuming a combined federal and state (Colorado) capital gain tax rate of 19.63 percent and a combined ordinary income tax rate of 39.63 percent, this structure would save approximately $200,000 in income tax.

The Bramblett Case

This pre-development sale technique has become more common as a result of the decision in Bramblett v. Commissioners.4 In Bramblett, the Fifth Circuit Court, reversing the Tax Court, held that profits from the sale of land from a partnership to a corporation were capital gains even though: (1) the partnership and corporation were owned by the same individuals in the same proportions; and (2) the corporation immediately developed and sold the property after purchasing it. The Fifth Circuit Court developed a framework to determine whether an entity in this scenario holds real property as an investment or as inventory and, thus, whether the pre-development appreciation is taxed as a capital gain or ordinary income.

The Tenth Circuit Court has not provided any guidance regarding this pre-development sale technique. Nevertheless, Colorado practitioners have used the Bramblett framework to minimize the risk of challenge by the Internal Revenue Service ("Service"). Although the requirements for capital gain treatment set forth in Bramblett are rigorous, they are not insurmountable if properly planned.

As discussed, the goal is to preserve capital gain treatment for appreciation of the land during ownership by the Investor LLC. The general rule is that for the sale of real estate to be taxed at the favorable capital gain rates, it must be held for at least one year. Further, the real estate must not be held as inventory or "held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business."5 The Bramblett case sets forth factors to be considered in determining whether the property in the hands of the Investor LLC should be treated as inventory or an investment for tax purposes.

Factual Background

The taxpayer in the Bramblett case was one of four partners in a partnership that purchased raw land.6 Shortly after this purchase, the four partners formed a corporation for the purpose of developing and selling the land. That corporation was owned by the same partners and in the same proportion as their ownership interests in the partnership.

Prior to the sale that was disputed by the Service, the partnership made four separate sales of portions of the land three of which were to the related corporation. They reported $70,000 of ordinary income from such sales. Subsequent to these sales, the partnership sought...