Real Estate Capital Gains

Real Estate Capital Gains

By: Martin M. Shenkman, CPA, MBA, JD

Sales of real estate can generate favorably taxed capital gains if you are an investor, or higher taxed ordinary income if you are a dealer. The following checklist will help you characterize your activities as those of an investor, and avoid dealer taint.

Capital gain is realized on the “sale or exchange” of real estate, which is not held primarily for sale to customers in the ordinary course of your trade or business.

(Code Section 1221(a)(1)). Investors do not sell to customers at a mark-up; rather they realize their profits from the long term appreciation of the property held. Dealers earn a profit by selling in excess of their cost as a result of their efforts and labors as middlemen. Investors, in contrast, don’t perform merchandising functions. The determination is fact sensitive. Your actions, and how you document them, are vital to your success. Corroborate and strengthen the factors consistent with capital asset characterization, and avoid, minimizing or downplaying the factors indicative of assets held primarily for sale in the ordinary course of business.

Try to avoid continuous sales of properties to purchasers.

Make sales sporadic, and over longer time periods if you can. Black v. Comr., 45 B.T.A. 204 (1941), acq., 1941-1 C.B. 2. Continuous and substantial activities suffice to characterize the taxpayer as a dealer, even without the other indicia of a trade or business. Suburban Realty Co. v. U.S., 615 F.2d 171 (5th Cir), cert. denied 449 U.S. 920 (1980).

Keep a diary.

Document the actual time you spend on development and marketing activities versus other activities. While devoting extensive time to the real estate endeavor alone will not taint a property as being held for sale to customers, it is a significant factor. Marrin v. Comr., 147 F.3d 147 (2d Cir. 1998).

Limit or avoid subdivision and other “improvement activity” to minimize the likelihood of the property being deemed as held for sale to customers.

Gruver v. Comr., 142 F. 2d 363 (4th Cir. 1944) Limit your development activities, subdivision work and lot sales to comply with the tax law exceptions from dealer status. Code Section 1237.

Minimize sales activity.

The greater the sales activity, the greater the likelihood of you being a dealer, and the property not to be a capital asset. Comr. V. Covington, 120 F.2d 768 (5th Cir. 1941). Hiring an independent broker to handle all sales activities may help if those activities are not imputed to you.

Have a single purpose LLC purchase investment property and minimize the involvement with your other entities.

A professional real estate developer and owner, who regularly buys and subdivides tracts of land, sells using sophisticated marketing techniques, and holds lots primarily for sale to customers that recognize ordinary income, not capital gains. Pierce v. Comr., 74 T.C.M. (CCH) 572 (1997).

Consider an intervening sale to characterize some gain as capital.

An increase in value due to appreciation while merely holding property, might be classified as capital gain, if you sell the property to a related entity before any development activities occur. Be certain to have an appraisal of the value at that date. Then, have the new entity conduct sales activities. If successful, only the profits attributable to development activities conducted by the related entity should be characterized as ordinary income.

Document your activities.

Substantial efforts to obtain subdivision approval, and to increase the value of the land increases the likelihood of ordinary income. Jarret v. Comr., 66 T.C.M. (CCH) 1224 (1993). Be careful though: “substantial” is a qualitative, and subjective term. So maintain a diary, correspondence, and other records to demonstrate how little effort you expended may defeat the substantiality issue.

Keep LLC minutes that corroborate that the purpose of the acquisition is to invest and hold the property.

Maintain contemporaneous records (e.g., business plans, memorandum, letters to counsel, etc.) that demonstrate the primary purpose was not holding the property primarily for sale.

Be sure your operating or partnership agreement supports investor status.

Sanford Homes, Inc. v. Comr., T.C. Memo 1986-404.

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