Techniques In Avoiding Dealer Status
In today’s real estate market being careful of having your investment property possibly taxed at ordinary rather than capital gains rates often deals with proper planning very early in the business investment cycle. This is particularly true if you want to convert your unimproved land or apartment building into condominiums. I discuss below how the use of multiple business entities can help secure the pre development appreciation to be taxed at capital gains rates rather than as ordinary income. The discussion below is based upon the assumption that investor wants to maximize his or her entire investments including sharing in the development phase of the investment business cycle.
Representing both investors in real estate as well as developers, I often counsel them to make certain that they have their investment properties in one type of business entity and if they are going to develop property to have those properties be transferred into another business entity. Most people are not developers. However, that does not mean that having different types of real estate (i.e. investment vs. development) owned by one business entity will not lead to adverse consequences.
I recently met with a client who exchanged his investment properties into two separate parcels that will be developed into condominiums. After reviewing the legal documents that were part of the development transaction, I informed him that the way they were drafted combined with only one business entity involved without a sale to the redevelopment entity first, that he more than likely will be taxed at ordinary rather than at capital gain rates. I gave to him a portion of an article entitled “Choice of Entities for Real Estate Development” written by James R. Hamill and Craig G. White that is part of the balance of this article.
Basic Concepts
Multiple business entities are often used to avoid exposing the assets of a taxpayer to the claims of creditors of a separate business operation. Separate entities are also used to obtain tax benefits that would be unavailable to a stand-alone entity. When separate entities are established for tax purposes, it is advisable to document the non-tax reasons for the existence of the separate entity to minimize the risk of an IRS attack.
Taxpayers have long attempted to avoid dealer status by contending that they are not in the trade or business of selling real property, or that even if they are in such a trade or business, a particular sale was not to customers of that trade or business, was not an ordinary sale transaction, or that a specific property was not held "primarily for sale." 1
A prime indicator of dealer status is a pattern of frequent and continuous sales activity. When land is improved, subdivided, marketed, and disposed of in frequent and continuous sales activities, it becomes very difficult to avoid dealer taint. In contrast, a sale of real property to a single buyer with little or no marketing activity and before substantial improvements have been made, should qualify for capital gain treatment for the amount realized on the sale. Thus, a tax planning technique with regard to the development of real property is for the taxpayer to sell the land in bulk to an entity controlled by the taxpayer and have the controlled entity conduct all dealer activities. Such a strategy should lock in the pre-development appreciation as a capital gain for the taxpayer with only the profit from development activities subject to ordinary income tax rates.
Raw Land Example
A and B, husband and wife, purchased undeveloped real property for $2 million in 1995. In 1999, the property in its undeveloped state is valued at $4 million, and A and B believe that they could earn an additional $1 million net profit by subdividing and improving the property and then selling 120 individual lots.
If A and B undertake the subdivision and improvement activities and sell the 120 lots, the $3 million profit ($2 million pre-development and $1 million development) will be taxed at ordinary income rates. If, instead, A and B establish X, a controlled entity, sell the undeveloped property to X for $4 million, and allow X to conduct the dealer activities, A and B will report a net capital gain of $2 million and X will report ordinary income of $1 million.
If this strategy is successful, federal income tax savings of $392,000 (19.6% rate differential × $2 million pre-development profit) will be realized. These savings require that the taxpayer satisfy the long-term holding period of more than one year in order to obtain capital gain treatment. It frequently happens that taxpayers contemplating sales to a controlled entity as part of their real estate development strategy cannot delay implementing the development so that a long-term holding period can be established. Getting around this potential problem will be addressed below as part of the discussion of using a 1031 exchange, pursuant to which the holding period for the property will be lengthened prior to recognition of gain.
Because land development activities involve significantly more risk than passive land investment, there is a bona fide business purpose for transferring the property to a controlled entity prior to commencing development work. In Example 1, A and B could select a corporation or a two-owner LLC, which would be a partnership for tax purposes, as the entity to conduct the development activities. For tax purposes, however, the more appropriate development entity would be a corporation because A and B intend to transfer the land by way of a taxable sale to the entity with the objective of realizing a capital gain on the sale. IRC Section 267 disallows the recognition of losses from sales between related parties, but there is no similar disallowance with regard to recognized gains from related-party transactions.
IRC Section 1239 treats gain from a sale of property between certain related parties as ordinary income, but only if the property is depreciable in the hands of the transferee. IRC Section 1239 may apply to a sale to a corporation in which the transferors own more than 50%, by value, of the stock, or to a partnership in which the transferors own more than 50% of the capital or profits interests. IRC Section 1239 would not apply to the transaction in Raw Land Example because land is not subject to an allowance for depreciation. Note, however, that IRC Section 707(b)(2)(A) treats gain from a sale of property as ordinary income if the sale is to a partnership in which the transferor owns more than 50% of the capital or profits interests and if the property is not a capital asset in the hands of the partnership. Accordingly, this provision would apply to a sale to a two-owner LLC that, by default, is recognized as a partnership for tax purposes. Thus, if A and B in Example 1 want to own 100% of the development entity, that entity must be a corporation (C or S) or an LLC that elects association status. To avoid an entity-level tax, an S election would be advisable for the corporation in these circumstances.
Apartments to Condominiums
Converting an apartment building into individual condominium units typically involves significant marketing activities and multiple individual sales over a short period of time. In this connection, a prime indicator of dealer status is frequent and continuous sales activity.It should also be noted that the IRS has long taken the position that a business activity that involves holding units for both rental and sale will result in dealer treatment for all gains realized on the sales. As with land development, the profit to be realized from a condominium conversion will consist of pre-conversion appreciation and the amount realized from post-conversion activities. The pre-conversion appreciation profit may qualify for capital gain treatment and the profit from conversion should be classified as ordinary income. If the owner of the property that is to be converted into a condominium wants to participate in post-conversion profits, he should, of course, acquire an interest in the conversion entity. Unlike a land development scenario, full participation in conversion profits in a condominium may be complicated by the depreciable nature of the property involved. Moreover, IRC Section 453(g) precludes installment reporting of gain from a sale of depreciable property to a controlled entity unless that taxpayer can demonstrate no principal purpose of tax avoidance.
As noted above, IRC Section 1239 provides that any gain realized from a sale of property to a controlled corporation or partnership is ordinary income if the property is depreciable in the hands of the transferee. IRC Section 707(b)(2) classifies any profit realized on a sale of property to a controlled partnership as ordinary income if the property is not a capital asset in the hands of the transferee. For purposes of both IRC Sections 1239 and 707(b)(2), control is defined as more than 50% ownership (value of stock for a corporation, capital or profits for a partnership). If the depreciable property rule applies, the vendor may not have more than a 50% ownership interest in the conversion entity, be it a corporation or a partnership. It may be argued, however, that the vendor could own 100% of a conversion corporation if the units are immediately saleable and therefore not depreciable. If the conversion entity is a partnership, the taxpayer cannot own more than 50% of the capital or profits interests because the conversion units would not be capital assets in the hands of a partnership.
To proceed with the condominium conversion, if IRC Section 1239 is a concern, the taxpayer could sell all units to a conversion entity in which he owns a 50% (or less) interest. Such a sale will result in a 15% tax rate on all gains other than the portion attributable to prior claimed depreciation, which will be subject to ordinary income rates if IRC Section 1250 recapture applies, or a 25% rate of tax otherwise. In this scenario, an LLC may be preferable to a corporation as the conversion entity. If a corporation in which the taxpayer owns a 50% interest is used as the conversion entity, it would be necessary to limit the other 50% ownership to one unrelated party to avoid the taxpayer's coming within the potential application of IRC Section 1239 . Use of an LLC as the conversion entity would make it easier to ensure that the taxpayer's interest in capital and profits does not exceed 50% because the taxpayer's interest could be limited to not more than 50% without the need to consider the relative value of the interests. Alternatively, if all units are to be held for immediate sale so that they would not be depreciable in the hands of the conversion entity, they could be sold in bulk to a 100% controlled conversion corporation. This strategy should also apply to units that are held for both rental and sale because such units would not be depreciable.
Any units that will continue to be rented and not held for immediate sale could remain in the taxpayer's hands so that he could realize additional appreciation on such units as an investment or sell such units in bulk to an investment partnership in which he owns not more than 50% of the capital or profits interest to lock in a net capital gain before such units could be tainted by ongoing sales and promotional activities of the units held for conversion. In either case, the bulk sale price should reflect the value of the units as rental units and not as converted condominiums. The taxpayer should avoid any sales or conversion promotional activities with regard to any of the units. Such activities should be undertaken solely by the conversion entity.
Once again, the sale to the conversion entity should not be collapsed as an exchange unless a taxable exchange can be structured. IRC Section 721, which is applicable to transfers to controlled partnerships, does not have explicit statutory provisions similar to either IRC Sections 357(b) or (c) or the nonqualified preferred stock rules. However, IRC Section 707(a)(2)(B) provides that a transfer of property to a partnership followed by a direct or indirect transfer of money or property to the transferor may be characterized as a sale. The Regulations interpreting this "disguised sale" rule contain provisions similar to IRC Section 357(b), including the treatment of certain debt incurred two years before or after the transfer as disguised sale proceeds. Refinancing an apartment building shortly before or after a transfer to a partnership with the taxpayer either keeping the refinance proceeds (pre-transfer) or receiving a debt-financed distribution (post-transfer) from the partnership could, if not properly structured, trigger a "disguised" sale. A disguised sale contention by the IRS would be available only if the taxpayer's profits or capital interest is not limited to 50% and would rely upon the IRC Section 752 liability sharing rules to trigger disguised sale proceeds. As with the affirmative use of IRC Section 357(b), there are risks associated with seeking to deliberately rely on an anti-abuse rule.
Conclusion
Use of multiple business entities and the choice of which ones to use can protect the pre development appreciation from being taxed at capital rather than at ordinary income tax rates. Proper planning and avoiding certain sales and development activities can be very beneficial in achieving this goal.