Dealer Status: Condos, Cash and Capital Gain, Part 2
Three methods apartment owners can use to reap condominium conversion profits without losing capital gains tax rates.
September 13, 2007
by Michael Hauser, CPA/JD
*This article is a condensed version of “Dealer Status and the Condominium Conversion” by Michael K. Hauser, published in the 2nd Quarter 2007 issue of Real Estate Taxation (WG&L). Reprinted with permission.
The marketplace has dictated that some apartment buildings are more profitable if converted to condominiums. Apartment building owners face a dilemma — if they sell a building intact to a condominium converter, they will pay capital gains tax (15-25%), but will not share in the profits from individual condominium sales. If they do the conversion themselves, maximizing their economic profit, then the conventional wisdom says they will pay tax at ordinary income rates (up to 35%). This increased tax load could outweigh the additional profits of conducting the conversion.
In last month’s column, I disclosed how to avoid the status of a ‘dealer’ in real estate. This article explores three methods of enabling the apartment owner to reap condominium conversion profits without losing capital gains tax rates.
In tax terms, “dealer” means a taxpayer who holds property primarily for sale to customers in the ordinary course of a trade or business. Dealers in real estate pay ordinary income tax because their real estate sales are like car sales made by auto dealers, just profits in the everyday operation of a business. However, rental properties are deemed to be held for use in the rental business, not held for sale. Since rental properties are held for a business/investment use, their sale produces capital gain. Typically, the sale of rental properties produces a substantial amount of capital gain because, even if economically the sale breaks even, the taxpayer’s basis in the property is low due to years of depreciation deductions which reduce the cost basis for tax purposes.
Example: Assume Fred buys an apartment building for $2 million. He owns it for 10 years and deducts $800,000 in depreciation, leaving him with $1.2 million of basis left. If the building were sold for $2.7 million, Fred would have $1.5 million in capital gain ($700,000 economic gain taxed at 15 percent and $800,000 recovery of past depreciation taxed at 25%). This translates to $305,000 in tax. Assume instead Fred converts the building and enters the everyday business of selling condominiums as inventory, ultimately selling them all (net of costs) for $3 million, an extra $300,000. Fred now has $1.8 million of ordinary income taxable at 35 percent, resulting in tax of $620,000. Thus, Fred actually loses on the conversion — though he gets an extra $300,000 in profits, his tax bill goes up by $315,000.
Pre-Conversion Sale to 50 Percent-Owned Entity
The easiest method to allow capital gain on a building conversion involves selling the building to a 50 percent-owned entity. In the example above, Fred would sell the building for $2.7 million (its value as a rental building) to Fred-Joe Corp., an entity half-owned by his partner Joe. This new corporation would do the conversion and collect the $300,000 in net conversion profits (taxable at 35%), but Fred’s initial sale would produce $1.5 million of capital gain taxable at 15 percent to 25 percent. Joe and Fred would have to be even-steven shareholders in all respects. Joe must own 50 percent because a sale of depreciable property between “related entities” produces ordinary income under Section 1239 of the tax code. An aggressive seller could attempt to capture additional conversion profits by taking a high-interest note back from the purchasing entity (seller-financing) or by taking a contingent interest “kicker” or participation right in the purchaser’s later sale proceeds. The 50 percent-line could get tested, and possibly crossed, if the seller’s “kicker” is considered a disguised form of equity in the new corporation.
Pre-Conversion Sale: The Over-50 Percent Method
An alternative strategy, which has not been tested in the courts or ruled on by the IRS, involves selling the building to a corporation with greater than 50 percent common ownership, perhaps even identical ownership. The taxpayer’s argument is that Section 1239 (described above) does not apply because the property is not depreciable in the hands of the purchaser, since the purchaser is holding the property as inventory for sale to customers (inventory is non-depreciable). Here, it is paramount to prevent the seller from being a “dealer” and yet to ensure that the purchasing corporation is in fact a “dealer” (to make sure the property becomes non-depreciable “inventory”). The new corporation must conduct the conversion (both the legal and business components) and try to sell the units as soon as is reasonably practicable (as leases expire and buyers become available). The sale terms must be arm’s length and there must be a business (nontax) purpose for the sale. There might be a business purpose if (1) there are differences in the ownership percentages; (2) financing is obtained more easily through a new entity; or (3) the new entity provides additional liability protection as between the condominiums and other property retained by the current owner (for example, if the building’s parking lot will not be sold with the condominiums, it could be retained by the original owner).
Though the conventional wisdom is that converting an apartment building into condominiums will bar capital gain, actual cases on the subject are mixed. There are cases, most notably Gangi, holding that the conversion of apartments into condominiums can be classified as merely the “orderly liquidation” of an investment, with the conversion activities too insubstantial to amount to the everyday “trade or business” of selling condominiums.
Relying on this method is generally frowned upon by practitioners due to its uncertainty, as compared to the pre-conversion sale. However, in the Parkside case, the roles were reversed and the IRS argued for the “orderly liquidation” theory since capital asset status was preferable to the IRS for other reasons. The fact that some cases approve of this method, coupled with the fact that even the IRS sometimes argues for this method, indicates that it has some vitality in the right circumstances, especially where the pre-conversion sale is not practical. The liquidation strategy can best be employed where (1) the evidence indicates that the taxpayer had a strong rental intent but made the conversion based on unforeseen circumstances which were out of the ordinary course of business, (2) the conversion-related physical renovation work is minimal, (3) the building has relatively few units, and (4) the sales, brokerage and advertising efforts are not excessive or prolonged.
Careful advance planning can avoid the heavy tax burden of recognizing all ordinary income on the sale of a depreciated apartment building as condominiums. The pre-conversion sale is generally the preferred method, with 50 percent-common ownership generally considered safe and above-50 percent considered aggressive but justifiable. In some cases, the liquidation theory may be adequately supported by the facts.
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Michael Hauser, Esq., CPA is a tax attorney with Maddin, Hauser, Wartell, Roth and Heller, P.C. in Southfield, Mich., who specializes in tax planning for small businesses. Hauser is an adjunct professor of real estate taxation in the LLM program at Cooley Law School.