Lower rates: planning strategies to sell real estate at lower long-term capital gain rates.

• Author: Briskin, Robert A.
• Position: REAL ESTATE TAXATION

Clients selling real estate desire in many cases to pay no tax by structuring their sale as an Internal Revenue Code Sec. 1031 tax-free exchange.

However, the goal of clients who choose to not do a tax-free exchange is generally to pay tax at lower long-term capital gain rates, 15 percent maximum federal rate, rather than at ordinary income tax rates, 35 percent maximum federal rate.

Additionally, there is a 9.3 percent maximum California state income tax on the sale's gain, and for tax years beginning after Jan. 1, 2005, there is an additional 1 percent California income tax surcharge for taxable income in excess of $1 million [California Rev. and Tax. Code Sec. 17043(a)].

Long-term capital gain rates apply to a sale of property that is a capital asset held more than one year. The following tax planning strategies will assist clients to achieve favorable long-term capital gain treatment.

CLIENTS WANT TO BE TAXED AT LONG-TERM CAPITAL GAIN RATES WHEN THEY SELL LAND DEVELOPED AS RESIDENTIAL LOTS OR CONDOMINIUMS.

Clients who subdivide land or develop land as condominium units, and then sell the subdivided and developed land, normally have their entire gain taxed at high ordinary income tax rates, since the client is classified as a "dealer" selling "inventory" in the form of subdivided lots or condominiums.

Instead of being taxed at ordinary rates on the entire gain, clients can be taxed at lower long-term capital gain rates on the land's appreciated value by engaging in the following tax plan:

First: The client, after owning the land in a partnership for more than one year, sells the land to a controlled subchapter S corp in exchange for an installment note. The IRC Sec. 1239 related party rules do not apply to make the gain ordinary because land is not a depreciable asset.

The S corp then develops and subdivides the land, obtains government entitlements, and constructs improvements and condominiums. An S corp, rather than a partnership or LLC, is used as the development entity because IRC Sec. 707(b)(2)(B) states that gain on the sale of property between two related partnerships results in ordinary income if the property is ordinary income property in the hands of the purchasing partnership.

The installment note, because of related party issues, should be on arm's-length terms and require a payment each time that a lot or condominium sold. The sale to the S corp must be bona fide and shift the burdens and benefits of the land's ownership to...