Type of Clients: Individuals who own appreciated land that will soon be subdivided, developed, and sold off.
Situation: It sure would be nice if long-term capital gain treatment could be claimed for predevelopment land appreciation.
Deadline: Before development activities commence.
Tax Action Required: Clients should consider selling appreciated land to a controlled S corporation that will conduct the subdividing and development activities.
With real estate values recovering in many parts of the country, some individuals, who have been holding raw land for investment, may now be ready to cash in by subdividing their acreage into parcels, developing them, and selling them off for big profits.
When the client takes this course of action, he or she is generally deemed by the tax law to be acting as a dealer in real property who is simply selling off inventory [see IRC Sec. 1221(a)(1) and Winthrop, 24 AFTR 2d 69-5760 (5th Cir. 1969) ]. When dealer status applies, the client’s entire profit, including the part attributable to predevelopment appreciation in the value of the land, is considered ordinary income. Therefore, it is taxed at the client’s regular federal rate, which can be as high as 39.6%. The 3.8% Net Investment Income Tax (NIIT) may apply too, which can push the combined federal rate up to as high as 43.4%. Rats! It would sure be nice if the client could pay lower long-term capital gains rates on at least part of the profit. As you know, the current maximum federal rate on long-term gains is 20%.
Even with the 3.8% NIIT added on, that would result in a maximum federal rate of “only” 23.8%, which is a lot better than 43.4%.
Fortunately, you may be able to help your client structure a deal that allows favorable long-term capital gain treatment for the predevelopment land appreciation, assuming the land really and truly was held for investment (i.e., the client is not already classified as a dealer with respect to the property). However, profits attributable to the later subdividing, development, and marketing activities will be considered ordinary income collected by a dealer in real property. Oh well. Since predevelopment appreciation is often the biggest part of the total profit, your client should be overjoyed to pay “only” 20% or 23.8% on that piece. The remainder of this release outlines a way to achieve this tax-saving goal.
Form S Corp to Function as Developer Entity
Say your client forms a new S corporation. He sells the appreciated raw land to the S corporation for its predevelopment FMV. Provided the client has held the land for investment (rather than as inventory for sale in the ordinary course of business as a real estate dealer) and has held it for more than one year, this sale will qualify for capital gain treatment. So your client will pay at most federal income taxes of “only” 23.8% of his whopping long-term gain.
After buying the land from the client, the S corporation proceeds to subdivide and develop the property, market it, and sell it off. The profits from these activities will be ordinary income passed through to the client. However, this is still a great tax-saving deal when the land is highly appreciated to start with.
To sum up so far, the developer entity strategy allows the client to lock in the favorable long-term capital gain treatment for all the predevelopment appreciation while paying higher ordinary income rates on the additional profits from development and related activities.
Consider Installment Sale Arrangement
If necessary, the sale of the appreciated land to the S corporation developer entity can be for a bit of cash and a lot of installment notes owed by the S corporation to the client. However, beware of overestimating the tax advantages of an installment sale.
- Deferring gain by using installment reporting wouldn’t turn out to be very smart if Congress increases the maximum long-term gain rate before the client collects all his notes from the S corporation, which could happen. The political winds are unpredictable. For this reason, the client may actually be well-advised to elect out of installment reporting to lock in the current relatively low long-term capital gains rates.
- Even if the client chooses to use installment reporting, the so-called second disposition rule will trigger deferred gains attributable to land sold by the S corporation within two years after buying it from the client [IRC Sec. 453(e) ].
- If the client uses installment reporting, he or she might fall under the dreaded installment sale interest charge rule of IRC Sec. 453A(a)(1). If so, the client must pay interest on at least part of the deferred federal income tax bill. That takes the fun out of using the installment method!
All things considered, it might be best to elect out of installment reporting and simply pay the 20% or 23.8% tax hit on the front end. If necessary, borrowing enough money to do so and incurring the resulting interest expense could be worth it. Of course, that’s for the client to decide.
Make Sure Developer Entity Is an S Corporation
The aforementioned developer entity strategy should work just fine, as long as you make the developer entity an S corporation rather than a controlled partnership (or multimember LLC treated as a partnership for tax purposes). Why? Because a little-known provision in IRC Sec. 707(b)(2) mandates ordinary income treatment for gain from a sale to a controlled partnership (or LLC treated as such) when the asset in question is not a capital asset in the hands of the partnership (or LLC). Since the land in our situation would not be a capital asset in the hands of the developer entity, any gain from selling the land to a developer entity that is a controlled partnership (or LLC) would be ordinary income. Of course, that would defeat the whole purpose-so use an S corporation as the developer entity.
Using a C corporation as the developer entity should also be avoided because that could result in double taxation of the profits from subdividing and developing the land.
Planning Ahead to Avoid IRS Objections
Finally, be aware of potential IRS arguments against the S corporation developer entity strategy and plan accordingly. For instance, the IRS may argue that what actually occurred was a capital contribution of appreciated land to the S corporation developer entity followed by development and sales activities. If successful, this argument would result in the entire profit being recognized as ordinary income belonging to the S corporation (as opposed to the bifurcated treatment we want).
The good news is that the taxpayer beat the IRS on this very issue in Bradshaw, 50 AFTR 2d 82-5238 (Ct. Cl.1982). Even so, the moral of the story is to carefully document and execute the sale between the client and the S corporation developer entity. If installment notes are involved, be sure the interest and principal get paid according to the terms of the notes. Do all the other things that indicate a sale rather than a capital contribution. Make sure the formation and capitalization of the S corporation and the sale of the land to the S corporation are completely separate and distinct events. Get the land appraised before the sale to the S corporation and charge an arm’s length price. Don’t let the S corporation issue any stock to the client at the same time the land sale is made.
Alternatively, the IRS could argue that the S corporation developer entity is actually the client’s agent. If this argument is successful, the purported sale of the land to the S corporation would be completely disregarded for tax purposes. The client would fall into dealer status, and all profits would be ordinary income.
More good news is found in Bramblett 69 AFTR 2d 92-1344 (5th Cir. 1992), where the Fifth Circuit rejected this agency argument, even though there were some “bad facts” in that case. Still, the moral of this second story is to keep the affairs of the client and the S corporation developer entity completely separate and distinct.
This will defeat any agency argument.
As long as there is a big difference between federal tax rates on ordinary income and long-term gains, the idea of “converting” ordinary income into long-term gains will remain a hot topic. In the right circumstances, the developer entity strategy outlined in this release can make you look really smart. Executed properly, the strategy should be above reproach.