Rising real estate prices have made property development an increasingly attractive opportunity for owners of undeveloped “raw” land. Property owners involved in development, however, can face very different tax consequences—and different returns on their investments—depending on their status as an investor subject to capital gains tax rates or as a dealer subject to higher ordinary income tax rates.
Property owners can improve returns on development projects by structuring their transaction to divide their investor and dealer activities between separate entities. This allows them to bifurcate their income between capital gains taxed at 15-20 percent and ordinary income taxed at up to 37 percent. Property owners considering this option must take care to understand the specific factors involved in these transactions and take steps to adhere to their requirements.
Investor or Dealer
Treasury Regulation §1.1402(a)-(4)(a) defines a real estate dealer as “an individual who is engaged in the business of selling real estate to customers” for gain and profit. Under this definition, a real estate owner who engages in development activity would be considered a dealer and the gains would be subject to ordinary income rates. The regulation provides an exclusion that encompasses investors, noting that “an individual who merely holds real estate for investment or speculation and receives rentals therefrom is not considered a real-estate dealer.”
A key distinction between investors and dealers is how they hold the property—as a capital asset or as property held for sale to customers. IRC Section 1221 defines a “capital asset” simply as property held by the taxpayer (whether or not connected with his trade or business). This excludes property that is used in the “stock in trade of the taxpayer,” property that “would properly be included in the inventory of the taxpayer,” or property held “primarily for sale to customers in the ordinary course of his trade or business.”
Tax Treatment of Investors
A property owner’s treatment as an investor or as a dealer can be a critical factor in the success of a development project, as the tax treatment of real estate investors provides certain benefits that are unavailable to dealers. Most significantly, gains from the sale of property held as a capital asset for more than a year are taxed at the 15-20 percent capital gains rate under IRC 1231. Additionally, investors can defer income recognition through an installment sale under which gains from the sale are recognized in a tax year after the sale has occurred. They can also use an IRC Section 1031 like-kind exchange under which they can exchange investment property for another investment property in order to defer recognition of gains or losses that would otherwise be required at the time of a sale. Investors, however, are subject to a $3,000 capital loss limit and must treat selling expenses as reductions in sales proceeds. Notably, undeveloped land is not depreciable.
By contrast, gains from the sale of property by real estate dealers are taxed at the higher ordinary income rate of up to 37 percent and are subject to the self-employment tax of up to 14.13 percent. Dealers also cannot depreciate property held as inventory, use the installment sale method to defer recognition of the gain, or use a Section 1031 like-kind exchange to defer income recognition. Dealers can, however, deduct a range of real estate selling expenses as ordinary business expenses and can deduct ordinary losses without limitation.
Avoiding Dealer Status
To improve returns on their property development projects, property owners should minimize their gains from dealer activities. To do this, they can use a so-called Bramblett structure to separate their investor activities from their dealer activities and thereby increase the amount of gain recognized as capital gain and decrease the amount of gain recognized as ordinary income.
Under a Bramblett structure, named after Bramblett v. Commissioner, 960 F 2d 526 (5th Cir. 1992), a property owner forms a partnership to purchase and hold property for investment or business use. The investor partnership then sells the property to an S corporation that is a related party, as defined under IRC Section 267, in an installment sale. This sale to the S corporation allows the investor partnership to avoid the conversion of capital gains into ordinary income under IRC Section 707(b)(2), which applies to transactions between a partner and the partnership. The S corporation then develops the land and sells the properties to third-party buyers, using the proceeds from the sales to pay the installment note.
Under this structure, property held by the investor partnership is treated as a capital asset, while property held by the developer S corporation is treated as inventory. The investor partnership recognizes income on the repayment of the note as long-term capital gains on the appreciation of the property, and the installment method allows the investor partnership to defer recognition of the gains. The developer S corporation, in turn, recognizes any gains from the third-party property sales as ordinary income.
Qualifying as a Bramblett Structure
There is no bright-line test for determining whether developer-owned real estate is a capital asset or property “held primarily for sale to customers in the ordinary course of a taxpayer's business inventory.” Instead, the IRS weighs the facts and circumstances of each case. The court in Bramblett used a three-question framework to make the determination: (1) whether the taxpayer is engaged in a trade or business, and if so, what business; (2) whether the taxpayer was holding the property primarily for sale in that business; and (3) if the sales contemplated by the taxpayer were “ordinary” sales in the course of that business.
The court also provided seven factors to consider when answering these questions: (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 and substantiality 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. Among these factors, the court stated that the “frequency and substantiality of sales” is the most important.
Depreciable Property Pitfall
Investors can use a Bramblett structure for the transfer and development of undeveloped land as well as for redevelopment projects, such as the redevelopment of apartments into condominiums or industrial property for residential use. For redevelopment projects, investors must be aware that property that contains a depreciable component could trigger the application of rules that require the recognition of gain by the investor partnership as ordinary income. Under IRC Section 1239, the investor partnership’s gain on the property could be taxed as ordinary income if the property qualifies as a depreciable capital asset for the developer S corporation. Additionally, IRC Section 453(g) prohibits the deferral of income from installment sales when depreciable property is sold to a related party.
Redevelopment projects could have a depreciable component either through acquisition, such as the acquisition of land that has an apartment building, or through development activity before the sale to the developer S corporation. In the example of an apartment building to be converted into condominiums, Section 1239 and Section 453(g) could apply if the developer S corporation can depreciate the building. Nonetheless, the developer would not be able to depreciate the building and the sections would not apply if the property is clearly held primarily for sale to customers as part of the developer S corporation’s business—resale of the apartments to customers—and not for use for the production of income, such as rental units.
To ensure that the purpose of the developer S corporation’s business in clear, property owners should delay development until after the developer S corporation acquires the property. If the investor partnership has made improvements, it must consider whether the activity converted the property from capital asset to property held “primarily for sale to customers in the ordinary course of his trade or business.” Property owners should also ensure that the developer S corporation’s activities put it within the definition of property held “primarily for sale to customers in the ordinary course of his trade or business” and does not qualify for depreciation deductions.
Assessing Your Options
Real estate owners who want to develop property should assess whether they qualify to use a Bramblett structure to reduce the amount of income recognized as ordinary income. They should consider the seven factors in determining whether sales of land are considered sales of a capital asset or sales of property held for sale to customers and adhere to its requirements. Overall, these factors focus on the intent of the seller at the time the property was acquired, improvements made to the property, and subsequent sales efforts.
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