Real estate investors must pay close attention to a property’s placed-in-service date and the start of the holding period when determining gain on a sale of property. The placed-in-service date for real estate begins the period when the taxpayer can start depreciating the property. The holding period determines whether the gain on the sale of the property is characterized as ordinary income, short-term capital gain, or long-term capital gain. The two dates are not always the same, and the difference between the two may significantly impact the profitability of a development project. This is particularly true when a project is sold shortly after it is completed.
Property owners in this situation can improve their returns by bifurcating holding periods into short-term and long-term components. This allows owners to both recognize basis accrued progressively and reduce the amount of their gain characterized as ordinary income.
Placed In Service Date or Holding Period?
Under the regulations for IRC Section 167, which governs depreciation deductions, property is considered to be placed in service when it is “first placed in a condition or state of readiness and availability for a specifically assigned function.” Many taxpayers mistakenly assume that the placed-in-service date is also the start of the holding period. The IRS clarified in Revenue Ruling 58-133 that “the acquisition date of property” determines the holding period for determining the character of gain or loss “regardless of whether the property was placed in service.” This is a critical distinction, as the start of the holding period determines whether the property is taxed at long-term rates under IRC Section 1231 or short-term tax rates under IRC Section 1221.
Progressive Holding Period
A building that is sold shortly after construction or redevelopment emphasizes the importance of understanding the difference between the placed-in-service date and the start of the holding period. In this situation, the holding period begins—and basis is acquired—progressively as the building is being constructed. The IRS noted in Rev. Rul. 75-524 that the “portion actually completed prior to  months before the date of sale is considered as held for more than  months for purposes of section 1231 of the Code.” The IRS specifically noted that the “date of completion or actual use of the entire building is not controlling” in determining the holding period for purposes of the character of gain or loss on sale.
In an apparent attempt to differentiate the two dates from one another, the IRS noted that “[f]or purposes of determining the depreciation deduction under section 167 of the Code, however, the period of depreciation for the building shall not begin until the building is placed in service.” In effect, Rev. Rul. 75-524 amplified Rev. Rul. 58-133, providing a practical framework for bifurcating holding periods into short-term and long-term components based on the timing of expenditures.
Example: Sale of Building Shortly after Construction
A typical investment scenario shows the impact of this framework. In this example, a taxpayer purchases undeveloped land with a cost basis of $1 million on October 31, 2018. After holding the land for a little more than a year, the taxpayer begins to develop a multi-family apartment building on the property on January 1, 2020 and incurs construction costs of $3 million on June 15, 2020 and $1 million on June 15, 2021. The project then receives a certificate of occupancy on June 30, 2021, which is the placed-in-service date, as it signifies that the property is “first placed in a condition or state of readiness and availability for a specifically assigned function.” Later in the year, the taxpayer sells the project to investors who agree to purchase the land and building for $8 million with a closing date of November 30, 2021, more than three years after the acquisition date. The land is ascribed a value of $2 million and the building is ascribed the remaining $6 million.
In this example, the taxpayer can begin to claim depreciation on the building on June 30, 2021, the placed in service date. The land had a cost basis of $1 million and the building had a cost basis of $4 million. In allocating the purchase price, the selling price of the land is $2 million with basis of $1 million. The land was held for more than one year, which results in a $1 million realized Section 1231 gain that is taxed as long-term capital gains at 20 percent. The selling price of the building is $6 million with basis of $4 million for a realized gain of $2 million.
The character of the gain on the sale of the building as of November 30, 2021 is less clear. If the start of the building holding period is the same as the placed-in-service date of June 15, 2021, the $2 million realized gain is ordinary income. However, when properly applying the principles in Rev. Rul. 75-524, the gain on the sale of the building is bifurcated and allocated between the building assets with different holding periods. The taxpayer has a holding period beginning on June 15, 2020 for $3 million of building and another holding period beginning on June 15, 2021 for the remaining $1 million.
With the $2 million gain on the sale of the building, the $3 million in basis allocated to the building with a holding period beginning June 15, 2020 results in long-term gain on three-quarters of the $2 million gain, or $1.5 million. The $1 million in basis allocated to the building with holding period beginning June 15, 2021 results in ordinary income on the remaining $500,000. The application of the principles in Rev. Rul. 75-524 resulted in a shift of $1.5 million of gain from ordinary income to long-term capital gain treatment.
The principals of Rev. Rul. 75-524 can have a significant impact on the profitability of a real estate development. It is particularly important for situations in which a property is sold before or shortly after it is completed, as it allows a property to reduce the amount of their gain characterized as ordinary income and taxed at higher rates.
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