| Capital Gains Bailout Transaction
The spread between 15% capital gain tax rates and 35% ordinary income tax rates provides a tremendous tax advantage to those who can make their transactions qualify for capital gain treatment. When it comes to the sale of real estate, the difference between ordinary income and capital gain treatment essentially turns on whether the seller is an “investor” or a “dealer”. Dealers for this purpose are basically developers who improve real estate in order to maximize their profit or who treat it as inventory to be held available for resale (e.g. “flippers”). Investors, on the other hand, are those who choose to invest their wealth in the form of real estate and take a more passive and long-term posture than a dealer. The lower capital gains rates are meant to encourage investment behavior and are thus available to anyone who qualifies as an investor. If you are considering developing real estate, the type of business entity you use to purchase, operate and sell the real estate and, more importantly, the way the entity and its operations are structured, can impact whether the entity is treated as an investor or a dealer.
Subject to certain adjustments, the tax due upon the sale of real estate is calculated as a percentage of the difference between the historical cost (basis) and the sales price net of closing costs. Take for example an apartment building purchased for $5,000,000 and then converted into a condominium with all of its units sold for net proceeds of $8,500,000. The taxable gain in this simplified example for illustration purposes is $3,500,000. If the seller is an investor, the capital gain tax would be $525,000 (3.5 * 15%). If the seller is considered to be a dealer, however, the tax is $1,225,000 (3.5 * 35%). The act of converting a building into a condominium with the intent to sell the units will almost certainly make the owner a “dealer” for tax purposes. Nevertheless, with proper planning and implementation, there is a way to have some or even most of the profit taxed as a capital gain.
In Bramblett v. Commissioner, 960 F.2d 526 (5th Cir. 1992), four individuals acquired several parcels of land using a partnership they formed for that purpose called Mesquite East. Mesquite East later sold the land for a profit to Town East, a corporation owned by the same individuals, which proceeded to develop the land and sell it to various third parties. Mesquite East reported the gain on the sale to Town East as a capital gain, arguing that it was an investor. By using this structure, part of the difference between Mesquite East’s purchase price and Town East’s sales price would be taxed as capital gain and part taxed as ordinary income, resulting ultimately in substantial tax savings to the four individuals. The IRS, however, taxed Mesquite’s profit as ordinary income, arguing that Mesquite was really in the business of selling land because of the development activities of Town East and its relationship to Mesquite East. One of the individuals took the case to Tax Court where the IRS made its argument and won. The individual then appealed to the Fifth Circuit Court of Appeals which reversed the Tax Court and held that the mere fact the Mesquite East had the same owners as Town East does not make Mesquite East a “dealer by association” subject to higher ordinary income tax rates. In doing so, the Court said that three principles must be considered when determining whether a property owner is a dealer:
(1) Was the taxpayer engaged in a trade or business, and if so, what business? (2) Was the taxpayer holding the property primarily for sale in that business? (3) Were the sales contemplated by the taxpayer "ordinary" in the course of that business?
Suburban Realty Co. v. U.S., 615 F.2d 171 (5th Cir. 1980). Seven factors which should be considered when answering these three questions are: (1) the nature and purpose of the acquisition of the property and the duration of the ownership; (2) the extent and nature of the taxpayer's efforts to sell the property; (3) the number, extent, continuity andsubstantiality of the sales; (4) the extent of subdividing, developing, and advertising to increase sales; (5) the use of a business office for the sale of the property; (6) the character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and (7) the time and effort the taxpayer habitually devoted to the sales. Id. at 178; Biedenharn, 526 F.2d at 415; Winthrop, 417 F.2d at 910. The frequency and substantiality of sales is the most important factor. Suburban Realty, 615 F.2d at 178; Biedenharn, 526 F.2d at 416
By carefully structuring, documenting and executing the transactions such as to satisfy these three principles and seven factors outlined in Bramblett and the cases it cites, capital gains can be “bailed out” of real estate projects during the early phases. With proper legal counsel, our condominium developer above, for example, could have split the project into two phases and created separate investor and developer entities to “bail out” $1,500,000 in capital gains. Under the right circumstances, the investor entity could have bought the building for the same price of $5,000,000 but first sold it to thedeveloper entity for $6,500,000 and paid capital gains tax on $1,500,000 (6.5 – 5.0). The developer entity would then pay ordinary income tax on a deflated profit $2,000,000 (8.5 - 6.5) instead of the $3,500,000 above when it sells out the project, resulting in a tax savings of $300,000 (1.5 * 20%).
By: Eduardo R. Arista, CPA, Esq.
Ph: (305) 444-7662
E-mail: Ed@AristaLaw.com
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