Robert A. Briskin

Clients selling real estate desire in many cases to pay no tax by structuring their sale as a Section 1031 tax-free exchange. However, where clients choose to not do a tax-free exchange, their goal is generally to pay tax at lower long-term capital gain rates (taxed at the 15% maximum Federal rate), rather than at ordinary income tax rates (taxed at the higher 35% maximum Federal rate). 1 Long-term capital gain rates apply to a sale of property which 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.

1. Clients want to be taxed at long-term capital gain rates when they sell land developed as residential lots or as 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 over one year sells the land2 to a controlled subchapter S corporation in exchange for an installment note. The S corporation will then develop and subdivide the land, and construct improvements and condominium units.3 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 unit is sold.4 Second , the installment note should have a specific due date (such as five years or less) and be secured by a deed of trust on the land in order to appear bona fide for tax purposes.5 Third , the development activities (such as obtaining subdivision entitlements and constructing the improvements) should be performed by the S corporation (and not the selling partnership) as the developer. Fourth , have a “business purpose” for the need of the S corporation as the developer, such as the need for different ownership and management by a separate corporation or the need of a separate developer corporation for liability protection. Finally , part of the developed project’s sales’ gain (which is taxed at ordinary rates) should be allocated to the S corporation in order to properly compensate the S corporation for its development activities.6

2. Client who has owned land for many years now wishes to subdivide that land into multiple parcels, and then sell these subdivided parcels at long-term capital gain rates .

In order for the client to not be classified as a dealer taxed at ordinary rates, and instead to receive long-term capital gain treatment, the client could utilize Section 1237. Section 1237 permits the client to receive long-term capital gain treatment when they subdivide land: (i) which is held for no less than five years; (ii) which is subdivided into no more than five lots; and (iii) which is not substantially improved by the client. Thus, the client can use Section 1237 to sell up to five subdivided lots to five different persons and still receive long-term capital gain treatment on the sale of these lots.7 Additionally, Section 1237 allows the client who holds land for at least 10 years to receive long-term capital gain treatment where the client only does infrastructure improvements (such as roads and utilities) for that land’s subdivision, but the cost of these improvements cannot be added to the land’s tax basis.8

3. How can a client who regularly bought and sold real estate in the past now receive long-term capital gain treatment on the sale of a new parcel of real estate?

Clients who might be classified as “dealers,” and taxed at high ordinary rates because they regularly bought and sold property in the past, can still structure their future sales transactions to be taxed at lower long-term capital gain rates. Although there is no bright-line test on how to receive long-term capital gain treatment, these “dealer” clients should consider taking the following actions: (i) the client should purchase new property (which they intend to later sell) in a separate single-asset tax entity; (ii) this single-asset entity should own the newly purchased property for as long a time as possible in order to evidence that entity’s intention to hold that property for appreciation and not for resale; (iii) the legal entity should not be controlled by persons who might be classified as “dealers” in property, and instead should be controlled by persons who would be classified as “investors”; (iv) the entity’s tax returns should show that the entity was an “investor” and not a developer or dealer of the property; (v) limit any improvements constructed on the property to be improvements for the property’s investment and holding purposes (such as a rental building), and not improvements for the subdivision and sale of the property (constructing roads and utilities for the land’s subdivision appears move as a dealer); (vi) the property should not be marketed for sale in multiple lots, nor should it be marketed with a broker immediately after its acquisition or improvement; and (vii) preferably, the property should be sold in the form of one legal lot to one person.

4. Client while still in escrow to purchase a parcel of property wants to sell that property to a new buyer at long-term capital gain rates .

Many times a client who is in escrow to purchase a particular property wants to sell that property while still in escrow at lower long-term capital gain rates. The client’s dilemma is that the client must satisfy the one-year capital gain holding period requirement which states that the property’s holding period commences on the date that the client closes that property’s purchase escrow . To satisfy this one-year holding period requirement, the client can engage in the following alternative tax strategy: The client sells the property’s escrow purchase contract (rather than selling the property) to the buyer. The escrow purchase contract is itself a capital asset for tax purposes since the purchase contract is to purchase land — a capital asset.9 This property’s purchase contract’s one-year holding period commenced on the date that the contract was signed (and not on the date that the property’s purchase escrow closes). Therefore, the client receives long-term capital gain treatment on the contract’s sale so long as the client sells this purchase contract more than one year after the client signed that contract. Additionally, the client can receive conditional cash deposits during the escrow period and not have to pay any tax on these received cash deposits until the sale of their purchase contract closes (at which time the client receives long-term capital gain treatment on these previously received cash deposits).10

5. Have the client have their real estate partnership interests redeemed in order to avoid being taxed at the higher 25% recapture tax rate .

Many times on the sale of property prior depreciation and amortization deductions will be “recaptured” and taxed at the higher 25% Federal recapture tax rate. If instead the property is owned in a partnership, this 25% tax can be avoided by having the partnership redeem the client’s partnership interest (rather than the partnership selling the property), resulting in the client’s entire redemption gain being taxed at lower long-term capital gain rates.11

6. Client desires to sell partially completed improvements at long-term capital gain rates .

Clients who commence constructing a building on land which the client has owned for several years may find a buyer before the client completes constructing that building. If the client were to sell the land and building during the construction process and then close the sale escrow after the building improvements are completed, the building improvements’ one-year capital gain holding period commence only upon those improvements’ date of completion. However, where the client has owned the land for more than one year, the land’s sale gain can still be taxed at long-term capital gain rates (even if the building improvements are not completed by the closing of the sale). Additionally, the “cost” of those building improvements which are completed one year before the sale are also taxed at lower long-term capital gain rates.12

1 Additionally, there is a 9.3% maximum California state income tax on the sale’s gain, and for tax years beginning after January 1, 2005 there is an additional 1% California income tax surcharge for taxable income in excess of $1,000,000. §17043(a) Rev. and Tax. Code.

2 The Section 1239 related party rules do not apply to make the gain ordinary because land is not a depreciable asset.

3 An S corporation, rather than a partnership or LLC, is used as the development entity because §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.

4 The sale to the S corporation must be bona fide and must shift the burdens and benefits of the land’s ownership to the S corporation for the transaction to be recognized for tax purposes. See Phelan, TCM 2004-206. The purchasing S corporation must not be classified as an “agent” of the selling partnership for tax purposes.

5 The installment note principal amount limit of $5,000,000, before interest is paid on the deferred tax liability, should not apply in most cases since this threshold limit applies on a per-partner basis at the partner level. §453A(b)(2).

6 The amount of ordinary taxed gain which is allocated to the S corporation should be minimized since California imposes a 1½% state corporate level tax on S corporation earnings.

7 If more than five subdivided lots are sold, then the gain for years in or after the year in which these additional lots are sold is taxed at ordinary rates to the extent of 5% of its selling price. §1237(b)(1).

8 See §1237(b)(3).

9 See William T. Gladden, 112 TC 209 (1999); rev’d and rem’d on other issues 88 AFTR2d 2001-5543 (9th Cir., 2001).

10 The client recognizes as income cash deposits only when the client has an unconditional right to retain those deposits. Thus, when the property’s (or contract’s) sale closes, the client recognizes capital gain income. If the sale does not close, any deposit monies retained by the client are taxed as ordinary income. See Jefferson Auto Parking Co., TC Memo 1963-266 and §1234(a)(1).

11 See Treas. Regs. 1.1(h)-1(b)(3)(ii).

12 See Russo, 68 TC 135 (1977), and Rev. Rul. 75-524, 1975-2 CB 342. The client should have an appraisal prepared to prove the “cost” of these building improvements which were completed one year before their sale.