Real estate investors consider several factors when buying and selling land to secure maximum possible gains, but often neglect to include taxes in their plans. Taxes on gains can be one of the largest costs of the transaction and since the spread between ordinary income tax rates and capital gain tax rates can be over 15%, a small mistake in how an investor structures the transaction can mean a big difference in the final, after-tax return. Working with an experienced accountant to plan for taxes will help you get the most out of your investment.
Most property owned for personal or investment purposes can be considered a capital asset. At the time of sale, capital assets held for more than one year yield gains that are taxed at a preferable tax rate—a long-term capital gain tax rate of no more than 23.8%. Conversely, gains from the sale of property that is not qualified as a capital asset will be taxed at the higher ordinary income tax rate up to 39.6%. To put this in perspective, a $1,000,000 gain taxed at ordinary rate of 39.6% results in $396,000 federal tax, whereas the same gain taxed at long-term capital gain rate of 23.8% results in $238,000 federal tax. As a result, the after-tax proceeds would be $762,000 to the seller taxed at the capital gain rate but only $604,000 to the seller taxed at the ordinary tax rates.
The difference in how these gains on real estate sales are characterized depends on the classification of the seller. An investor is awarded capital gain tax treatment, while the gains on the transactions of a dealer are taxed at the ordinary income rate. Investors are defined as those who retain property for personal or investment purposes, and dealers as those who maintain inventory property, property held primarily for sale to customers in the ordinary course of business and real property used in trade or business. Despite the intent and the duration for which property is held, certain activities such as subdividing, renovating, developing or advertising property can threaten an investor’s preferential capital gain tax treatment.
As noted in the example above, the difference in federal tax levied on an ordinary gain versus that on a capital gain is substantial. However, there are legal precedents and financial strategies that can help to ensure that gains—or losses—from a sale of real estate property are taxed at the capital rate. Thus, performing the proper due diligence, tax planning and implementation of strategies from the outset can effectively save real estate holders a considerable amount of money. But the protection for capital gain tax treatment ultimately lies in the quality of the planning that is undertaken. The effectiveness of these strategies can and will often fail when inexperienced or uninformed taxpayers engage in them without the guidance of an accountant.
Strategies for Preserving Capital Gain Tax Treatment
Some parts of the tax code offer clear guidance to taxpayers that allow them to plan their transactions without substantial tax research. Unfortunately, the tax code is unclear on what real estate transactions qualify for capital gain treatment that the IRS has often challenged taxpayers who have reported capital gains and taxpayers have taken the issue to court dozens of times. This has resulted in substantial case history that helps define the following relevant factors to use when deciding the character of a gain.
Purpose for Holding
The purpose for which a seller originally held the property is often a substantial indication of investor or dealer status. At its foundation and without evidence of a significant change, original purpose defines whether property is held for investment or sale. A significant change in holding purpose is often indicated to the courts by examination of whether improvements were made to the property, or if the owner undertook noteworthy advertising and marketing efforts prior to sale. An exception to this is if a seller can show that the change in purpose was influenced by unexpected external factors which made the original purpose of the holding impossible. In these cases, documentation of the original purpose for holding at the time of purchase can play a substantial role in protecting preferential tax treatment. If a change in purpose arises, evidence of factors that induced the change should be recorded as well.
Selling and Development Activities
The extent and nature of a property holder’s efforts to sell has often been assessed in determining the characterization of the gain. In previous cases, such as Ferguson v. Comm’r, 53T.C.M. 864 (1987) and Thompson v. Commissioner, 322 F.2d 122 (1963), the courts established that properties originally held as investments would be taxed at the ordinary income rate due to the activities undertaken by the seller, or on the seller’s behalf, prior to sale. These cases specifically illustrate that the level of solicitation and advertisement for a sale can indicate that a seller is actively seeking to create buyer interest. As such, this seller can then be classified as a dealer.
Similarly, courts have historically been more inclined to treat sales as ordinary in nature when a property holder engages in development activities, especially when combined with a high frequency of sales. Development activities can constitute a number of different actions undertaken by the seller or on behalf of the seller. In the obvious sense, executing significant improvements on and subdivisions of property can be categorized under development activities. In certain cases, however, solely making arrangements to subdivide property has influenced courts to deny capital gain tax treatment. Additional development activities that have prompted the denial of capital gain treatment can be found here.
Property Separation and Sales
A court assessing the characterization of a gain on the sale of property may be influenced by the number, extent and continuity of sales executed by the holder. Though there is no explicit rule as to how many sales constitutes ordinary business, case history provides a degree of guidance. In Suburban Realty Co. v. United States, 615 F.2d 171, the court ruled that 244 sales in one year could be considered an act of trade of business. Similarly, a court may analyze the percent of a seller’s income that is made from realty sales each year.
Sellers who regularly maintain property as both an investor and a dealer should do so through separate legal entities. Without this structure, sellers risk subjecting their investment holdings to ordinary income tax treatment. A viable strategy for separating properties is to form a limited liability company that is used to hold undeveloped investment properties. This LLC should be formed by the dealer and a third-party as a partnership, so as to avoid receiving disregarded entity status from the IRS. This separation of holdings will allow a dealer or developer to perform the necessary sale activities in the course of their regular course of business without risking loss of preferential treatment to their investment properties.
If a property owner is seeking to make significant improvements to their investment property, but wants to maintain the preferential tax treatment at the time of sale, they may sell the property to a developer in an arms-length transaction. Though the developer will be responsible for the less favorable tax treatment on any gain from sale, the profits on a sale of the developed property will outweigh the ordinary income tax liability, thus making the transaction favorable to both the investor and the developer.
There is another section of tax law that can be utilized independently of the other rules, wherein a taxpayer can recognize 100% of income generated as capital gains. The “Safe Harbor” rule allows for gains on the sale of up to five lots of a property per year to be recognized as capital. Any additional lots thereafter are treated as ordinary income under the condition that 5% of the sale price exceed any and all selling expenses. Any excess gain over that amount would be considered capital gain as well.
The rule is designed to specifically protect non-dealers or “flippers” though, and includes provisions to weed out grey areas through caveats such as that the taxpayer has not made improvements that substantially enhance the value of the property and that the property has been held for at least five years.
bgr CPAs professionals have helped real-estate clients for over 75 years. Throughout the Mid-Atlantic region we have assisted land developers, apartment owners, home builders, and property management companies with their tax, accounting, and business needs. To learn more about the effect of capital gains on your business, please contact Michelle Outerbridge, CPA, CFP at firstname.lastname@example.org or Paul Turner, CPA at email@example.com or (410) 418-4400.