Capital Gain or Ordinary Income?

The difference between being treated as a real estate dealer versus investor and how a strategy called land banking can help achieve more favorable capital gain treatment.

Perhaps the most common issue that arises when a taxpayer sells appreciated real estate is whether the gain should be characterized as capital gain or ordinary income. With the top ordinary income rate being nearly double the capital gains rate, the difference can be substantial.

In order for a sale to result in capital gains, the underlying asset must be a capital asset.

The Internal Revenue Code (the Code) defines a capital asset by exclusion; providing that an asset is not a capital asset if it is “held by the taxpayer primarily for the sale to customers in the ordinary course of his trade or business (§1221(a)(1)).”

A taxpayer who holds property for sale to customers in the ordinary course of business is considered a “dealer”. The property is treated as inventory and any gain resulting from the sale of the property is ordinary income, subject to a top federal rate of 43.4%. Conversely, if the taxpayer does not hold the property for sale to customers in the ordinary course of business, the property is a capital asset (provided no other exclusions from capital asset treatment apply), and any resulting gain is taxed at the more favorable capital gain rates, which under current law, top out at 23.8%.

Whether real estate is “held by a taxpayer for sale to customers in the ordinary course of business” is among the more controversial and heavily litigated issues in the tax law. The courts look to the following factors in determining whether the sale of real property should be treated as the sale of a capital asset: Whether the taxpayer (1) is engaged in the trade or business of selling real property, (2) holds the specific property at issue primarily for sale in that business, and (3) made the specific sale at issue in the ordinary course of that business.

In United States v. Winthrop, the court identified seven factors, the “Winthrop Factors,” which are frequently used to evaluatethe three criteria above:

It is important to note that the factors are generally intended to have equal weight; however, various courts have emphasized certain factors more than others. In other words, it is possible for a taxpayer to “pass” five or six of the seven factors and still lose capital gain treatment if the court feels strongly enough about the remaining factors. Many courts have disregarded the absence of factors two, five, six and seven, which deal with sales measures, due to the fact that some sellers are not required to advertise when they are fortunate enough to operate in a market with active demand for their product. Taxpayers who fail the test and lose capital gain treatment often have some combination of the first, third or fourth factors against them.

The first factor focuses on the taxpayer’s nature and purpose of holding the property as well as the length of time that the taxpayer held the property. The main concern is the taxpayer’s purpose for holding the property “at some point before the sale.” In other words, the courts recognize that a taxpayer may purchase a piece of real estate for a certain purpose and then the holding purpose may change due to a variety of factors. For example, real property can be purchased with the intention of constructing a custom home for resale and can then be repurposed and held for investment after a downturn in the housing market. Although the focus is on the holding purpose before the sale, the courts will most likely start with the original intention and place the burden of proof on the taxpayer to show that there was a legitimate change in purpose prior to the eventual disposition. Also, longer holding periods generally help support capital gain treatment since investors tend to hold property longer while dealers “in the business” of selling real estate generally want to turn each property over as soon as possible; however, holding period alone will not guarantee capital gain treatment.

The third factor deals with the number, extent, continuity and substantiality of the sales. In many cases, this seems to be the most significant factor considered by the courts. The premise here is similar to the first factor in that the courts are trying to determine whether the taxpayer is a dealer in the business of selling real estate or simply an investor trying to make a profit on the appreciation of his investment. When do sales become “substantial”? That is the key question and it can be answered differently by every court. For example, in Suburban Realty Company v. United States, the sale of 244 lots over a 32-year period was held by the court to be continuous and substantial while in Byram v. Commissioner, 22 sales over a 3-year period was not “sufficiently frequent or continuous to compel an inference of intent to hold the property for sale rather than investment.” In both cases, the average over the period in question was approximately 7 sales per year. In Winthrop, the sale of 456 lots over 18 years (25 average) was frequent and substantial which may seem logical to most people, but in Lewellen v. Commissioner, 31 sales over a 12-year period (2.5 average) was also considered frequent and substantial which may not be as clear.

The fourth factor examines the extent of subdividing, developing and advertising performed by the taxpayer in relation to the property. The rationale is that investors will do little, if anything, to improve the property held as an investment while dealers are more likely to engage in development activities to make the property more saleable. For instance, a dealer who purchases a tract of land, goes through the subdivision process with the municipality and installs utilities on the property will find it nearly impossible to prove that he is merely holding the property for investment purposes. Conversely, an investor who purchases unimproved land and takes no action to improve the property prior to selling it will have this factor in his or her favor.

It quickly becomes evident from the discussion above that proving intent to a court based on factors that are largely subjective and left to interpretation is an uphill battle, with an uncertain outcome that many taxpayers are not comfortable facing. The use of a strategy called “land banking” can be an attractive option for taxpayers in this position and, when structured properly, can save substantial tax dollars. Land banking seeks to separate the appreciation of real property held for investment (capital gain) from the increased value associated with developing the property for resale (ordinary income).

To illustrate, assume a developer buys a plot of vacant land for $1M with the intent of holding the property for 10 years or more in hopes that it will appreciate in value and produce a sizable gain. This certainly sounds like an investment. Now assume in year 11, property values have increased due to expansion of a nearby city and the fair market value of the land has increased to $6M. The developer believes that the best use of the land would be to construct a retail strip mall on the property and sell it to a third party so he spends $3M constructing the strip mall and sells the property for $10M. What is the taxpayer’s gain and should it be taxed as a capital gain or ordinary income? Simple math tells us that the overall gain is $6M ($10M sales price less $4M basis). After considering the taxpayer’s other activities and applying the seven factors discussed above, it is likely that a court would find this transaction as taking place in the ordinary course of the taxpayer’s real estate development business and the $6M gain would be taxed at ordinary income rates. But, consider that $5M of the gain was the result of appreciation in market value alone over a 10 year period and had nothing to do with development or sales actions taken by the taxpayer. Only $1M of the gain resulted from the taxpayer’s development activities. Should $5M be treated as capital gain and only $1M be treated as ordinary income? A properly structured land banking transaction can achieve this result.

Land banking allows a taxpayer to sell land to a related party for development and recognize capital gain income on the sale. In the example above, if the taxpayer originally purchased and held the land for investment in a real estate investment entity, and then sold the land to a separate development entity to develop and resell to a third party, the taxpayer could recognize a $5M capital gain on the first sale and a $1M ordinary gain on the second sale. Tax courts and the IRS have both recognized these transactions as valid in the proper circumstances; however, there are many important steps that must be taken to ensure the proper criteria are met. For example, the related development entity must be an S-corporation since the statutes governing partnerships would convert the gain to ordinary income. Also, there must be an independent business purpose for the transaction (other than to save tax dollars) and the transaction should mirror that of two unrelated parties operating in the normal course of business. The business purpose requirement can be satisfied by the fact that the investment company would want to insulate its other investments from the development activities performed on the property in question. In order to conduct the transaction in a manner that is ordinary and customary in the business environment, an independent appraisal should be conducted to show the value of the property prior to selling it to the development company and taxpayers must be sure not to artificially inflate the value in order to maximize the capital gain on the first sale. Also, the formalities of a typical sale should be observed including a down payment and loan terms that are in line with the current marketplace. While acquiring the property from the investment entity with 100% financing won’t automatically negate capital gain treatment, it can be a strike against the taxpayer if the market would normally require a down payment.

Taxpayers who operate in the real estate industry are constantly faced with the risk that development and sales activities will convert capital gain from the appreciation of real estate to ordinary income in the eyes of the IRS. The burden of proof rests on the taxpayer and, although the taxpayer may believe that he or she passes most, if not all, of the seven factors suggesting capital gain treatment, the ultimate decision rests with the IRS and the tax courts. Rather than accepting such uncertainty, taxpayers in this industry may find that a properly structured land banking transaction will be beneficial in mitigating the risk. Due to the complexities surrounding the underlying regulations and the IRS’s desire to challenge these sales as producing ordinary income, it is imperative that taxpayers and their advisors understand the rules and structure the transactions properly.

To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.