Capital Gain or Ordinary Income? What Real Estate Developers Need to Know.

Posted on 08.20.18

Capital Gain or Ordinary Income? What Real Estate Developers Need to Know.

Tax Court Rules Sale of Land by Former Development Entity was Held for Investment

By: R. Darden Bell, III, CPA, Tax Senior Manager | Real Estate & Construction Industry Team

Achieving capital gain treatment rather than ordinary income treatment from the sale of appreciated land is on the wish list of most taxpayers, whether a developer or not. A few years ago, we published an article outlining the best practices to accomplish such a capital gain bailout strategy

Given the difference between ordinary income tax rates and capital gain tax rates, it is easy to understand why the IRS might challenge a taxpayer’s reporting of a sale as capital gain instead of ordinary income. Fortunately, the U.S.Tax Court (the Court) recently ruled in the taxpayer’s favor on such a case. In Sugar Land Ranch Development, LLC, et al v. Comm., the IRS contended that Sugar Land Ranch Development, LLC (SLRD) sold land held in the ordinary course of their business, and the gain should have been taxed as ordinary income instead of capital gain as reported by the taxpayers. Luckily for the taxpayers, the Court considered all relevant factors of the situation before coming to a decision.

SLRD purchased almost 1,000 acres of land in Sugar Land, Texas in 1998 and did in fact intend to subdivide and develop the land into single-family homes with some surrounding commercial properties. The land was an old oil field, so preparing it for development was a lengthy process. Between 1998 and 2008, SLRD remediated the property, built a levee, and entered into a development agreement with the City of Sugar Land, Texas. Then, the economic downturn and mortgage crisis hit. In late 2008, the managers of SLRD decided not to develop the property, and instead, would hold the property as an investment until the market recovered. These decisions were documented in a “Unanimous Consent” document executed on December 16, 2008, by the managers and members of SLRD. Between 2008 and 2012, the land sat dormant. SLRD did not develop the parcels in any way, nor did they market the parcels for sale. In 2011, an unrelated developer approached SLRD about buying the land for potential development. All of the land, which was held in three separate tracts, was sold to this unrelated developer. The sales contracts also included provisions that resulted in SLRD receiving payments for each plat recorded on the land in the future and payments equaling 2 percent of the final sale price of each future home. While these additional payment provisions were part of the land sales contracts, no payments from this provision were received in 2012, the year in question. 

The IRS pointed to a variety of factors as to why this gain should be ordinary trade or business income: the entity was originally formed for development purposes; some development activity did take place on the land while it was held by SLRD; there were contingent payments based on future development; and the fact that the SLRD tax return stated their primary business purpose was Real Estate Development. The IRS also tried to attribute trade or business activity from a related entity on an adjacent property to SLRD.

As our previous article on this topic explains, there are seven factors that should be considered in determining whether real estate is held in the ordinary course of business or as an investment. In this case, the U.S. Tax Court did just that. The Court held that a taxpayer is “entitled to show that its primary purpose changed to, or back to, ‘for investment.’” SLRD made such showing in their unanimous consent document from 2008. The Court also held that any development activity that occurred before the marked change in purpose is largely irrelevant. The Court also pointed to how infrequent SLRD’s sales were and that SLRD did not market the parcels, solicit purchasers, or devote any time to selling the land. The Court explained that the transaction was essentially a bulk sale of a single, large, and contiguous tract of land, which was clearly not a frequent occurrence in SLRD’s ordinary business. The parcels had not been subdivided when they were sold, and little or no development activity occurred on those parcels for at least three years prior to the sale. Upon examination of capitalized costs incurred, the Court found that most costs were consistent with investment intent (holding costs) or appeared to have been related to other parcels. Furthermore, since none of the contingent payments based on plats or home sales were received in 2012, they were deemed irrelevant to the 2012 gain on sale. The Court could only assume those payments would be treated as ordinary income when received in the future, but would not go so far as to taint the 2012 sales for this reason.

In the end, the U.S. Tax Court ruled that the gain from the sale should indeed be considered from the sale of investment property rather than from property held in the ordinary course of business, thus resulting in capital gains treatment. This court case is a good example of how to properly execute a capital gain bailout strategy, even if you are a developer holding land. The taxpayers in this case did what was needed in order to show investment intent, other than changing their principal business activity from real estate development. Developers currently holding land for development should keep this strategy in their back pocket. Even after tax reform, there remains a significant difference between ordinary income and capital gains tax rates. Knowing how to create the proper paper trail and fact pattern to achieve capital gain treatment is crucial. If you have any questions or concerns, please reach out to your Keiter team member, or myself. We are always happy to help.  Email | 804.747.0000

Sources:

Sugar Land Ranch Development, LLC, et al. v. Commissioner, TC Memo 2018-21

The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.

Posted by: Darden Bell, CPA

Darden is focused on providing high level service to clients in a variety of industries.  He has considerable experience serving clients in the Real Estate and Construction industry. He is a member of Keiter’s Real Estate and Construction team. Read more of Darden’s insights on our blog.