Achieving capital gains treatment on predevelopment real property appreciation.

• Author: Wells, Thomas O.

Considering the dramatic appreciation in real estate values and strong residential markets fueled by consumer demand and inexpensive financing, many property owners are undertaking their own development--often condominium or other multi-unit projects--rather than selling the underlying real estate to a third party developer. Unit sales result in ordinary income to the developer, and profitability can be affected substantially where, as is often the case, the underlying real estate has appreciated prior to development. With planning, appreciated land values may be subjected to the favorable capital gains tax rate instead of the higher ordinary income rates. Several common scenarios highlight this opportunity. For example, developers may wish to hold back some units from the initial sales and marketing effort for leasing and investment purposes and to obtain capital gains treatment upon ultimate sale. In addition, to avoid subjecting pre-development appreciation to ordinary income tax rates, some owners have implemented a "capital gains bailout" strategy, by selling the pre-development property (that is, before development entitlements are procured) to an entity controlled by the owner which in turn develops the property and sells the units.

This article reviews basic income taxation principles for real estate investors and developers, explains the mechanics of a "capital gains bailout" transaction for pre-development and post-development planning purposes, and highlights the income tax benefits derived from such a transaction.

General Property Tax Principles

The gain upon sale of a capital asset held for more than 12 months, other than by a "C" corporation, is subject to the 15 percent federal long-term capital gains tax rate. However, a "capital asset" in this context excludes property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business. (1) In a typical real estate development scenario, developer-owned lots or units intended for sale to consumers would not be deemed capital assets, and the gain realized when they are sold, therefore, would be subject to the higher 35 percent ordinary income tax rates. Profit margins may be affected significantly by the material difference between the federal income tax rate of 35 percent and the federal long-term capital gains tax rate of 15 percent.

Dealer Versus Holder of Capital Asset

Whether developer-owned real estate may be considered a capital asset depends on a fact-oriented analysis of the taxpayer's purpose in holding the property. Courts have focused on a number of factors to distinguish a capital asset from property held for sale to customers. For example, in US. v. Winthrop, 417 F.2d 905 (5th Cir. 1969), the Fifth Circuit cited the following seven factors as critical to the analysis of whether real estate qualifies as a capital asset in the hands of a taxpayer:

(1) the nature and purpose of the acquisition of the property and the duration of ownership;

(2) the extent and nature of sales efforts;

(3) the number, extent, continuity and substantiality of sales;

(4) the extent of subdividing, developing and advertising to increase sales;

(5) the use of a business office for sales;

(6) the taxpayer's control over sales representatives; and

(7) the amount of time and effort habitually devoted to selling.

No one factor is determinative and there is no bright-line test. (2) The likelihood that a taxpayer would be deemed a dealer (as opposed to holder of a capital asset) increases as the number and regularity of the taxpayer's sales increase, and as the taxpayer intensifies sales and marketing efforts by such things as improving the property or soliciting buyers. (3)

Treasury Regulation [section] 1.1402(a)(4)(a) defines a real estate dealer (subject as such to ordinary income tax rates) as follows:

In general, an individual who is engaged in the business of selling real estate to customers with a view to the gains and profits that may be derived from such sales is a real-estate dealer. On the other hand, an individual who merely holds real estate for investment or speculation and receives rentals therefrom is not considered a real-estate dealer.

Capital Assets Subject to Ordinary Income Treatment

Assuming a taxpayer has satisfied the "capital asset" test for capital gains treatment, certain provisions in the Internal Revenue Code nevertheless potentially convert capital gains into ordinary income, when the taxpayer sells a capital asset to a related party. However, these code sections apply to a limited universe of transactions. For example, IRC [section] 707(b)(2) imposes ordinary income treatment on gain from a sale of a capital asset between commonly controlled partnerships (defined as partnerships in which the same persons own, directly or indirectly, more than 50 percent of the profits or capital interests in both partnerships), when the asset is not a capital asset in the hands of the purchasing partnership. The same result occurs under the same code section on a sale by a morethan-50 percent partner (again, based on either profits or capital interest) to his or her partnership, where the...