The Capital Gain Conundrum: Avoiding the Status of a ‘Dealer’ in Real Estate
Advance planning and a business purpose can make all the difference.
August 9, 2007
by Michael Hauser, CPA/JD
As many of you are aware, a federal tax rate discount of up to 20 percent is available for sales of “capital” assets (property held for long-term market appreciation), as opposed to sales of “dealer” property (property bought and sold as a business). The tax break is available to individuals, partnerships and “S” corporations that sell capital assets they have owned for over one year. You may not be aware that sales of capital assets qualify for two additional benefits — first, gain from seller-financed sales of capital assets can be deferred under the installment sale rules of § 453 and, second, the gain from sales of capital assets can be deferred through a § 1031 exchange. But none of these tax benefits are available for “dealer” property.
This begs the question: Is real estate considered a “dealer” asset? It is widely presumed that developers and frequent real estate sellers are tainted as “dealers” and will never have capital gain from the sale of real estate. However, the actual rule is that capital gains cannot result from “property held primarily for sale to customers in the ordinary course of a trade or business.” Thus, even a taxpayer actively engaged in real estate can claim capital gains from the sale of real estate which (1) is held primarily for investment, rental or intended future rental, (2) is not sold as part of an established trade or business, or (3) is not sold within the ordinary course of the taxpayer’s business. Thus, a facts-and-circumstances test will determine whether a real estate asset is dealer property.
Avoiding Dealer Status
Planning can make the difference in avoiding dealer status by helping to create positive facts related to the facts-and-circumstances test. For example, when feasible, each parcel should be held in a separate entity. Related entities are generally considered distinct “taxpayers” even if they have the same owner or owners (“entity-level characterization”). Even if a taxpayer would be a “dealer” if he or she bought and sold properties through a single entity, “dealer” status could possibly be avoided if each property is owned through a separate entity. Note: For an LLC to be a recognized entity for tax purposes, it must have more than one member or it must elect to be taxed as a corporation. In the partnership context, the Supreme Court has held that, for purposes of “ascertain[ing] and report[ing]” a partnership's income, “the partnership is regarded as an independently recognizable entity apart from the aggregate of its partners” (Basye, 410 U.S. 441 (1973)).
Thus, in a case involving the sale of residential real estate, the Tax Court stated that “the partnership is to be viewed as an entity and [gain and loss] items are to be characterized from the viewpoint of the partnership rather than from the viewpoint of the individual partner” (Podell, 55 TC 429 (1970)). Similar rules apply in the case of an S corporation. It is still somewhat helpful if the related entities have at least some differences in their ownership composition, but even identical ownership has been approved of in the case law, most notably in Phelan, TC Memo 2004–206 and Bramblett, 960 F.2d 526 (5th Cir. 1992.)
For taxpayers who are “dealers,” each parcel is considered separately to determine if it is dealer property. Taxpayers and their professional advisers should collect evidence that parcels are held for investment, as opposed to being held for sale in the ordinary course of a trade or business. In transaction documents, it is helpful to have self-serving language evidence “investment” intent, and to avoid the terms dealer, development and sales. These terms (good or bad) may appear in the recitals to the purchase agreement, in the entity’s legal name, on the tax return and in the entity’s statement of purpose in its Articles of Organization or Operating Agreement.
How can a residential builder who primarily sells single-family homes in the ordinary course of a business avoid dealer status? They may be able to divide profits between capital gains (on land appreciation) and ordinary income (on building profits). Assume an LLC buys land, begins development two years later, and then subdivides and sells individual residential units. Since the LLC is engaged in development, the profits would be ordinary income. Assume instead the LLC passively held title to the land for investment (as evidenced by the documents mentioned above), while a separate S corporation (with the same owners) obtains government approvals and orders surveys, blueprints and architectural work (as evidenced by having correspondence and payments for these items come from the S corporation). Just before development, when the project has appreciated due to market factors and rezoning, the property gets sold from the LLC to the S corporation. The raw land sale could produce capital gain on the pre-development appreciation (and most of the capital gain itself could get deferred through an installment sale/“wrap mortgage” arrangement).
Whether or not this method is viable depends on some critical factors. First, a business purpose for the related-party sale, apart from tax motivations, is essential. Often a business purpose can be justified on a “limitation of liabilities” or “segregation of liabilities” theory. In Bramblett, a sale from a general partnership to an S corporation, both of which had the exact same owners, was considered a legitimate transaction for tax purposes because the owners had a business purpose of moving the property to a corporation before beginning development work so that they would receive limited liability under state law. In Phelan, an LLC sold real estate to an identically owned S corporation — however, there was a business purpose since less than the entire parcel was going to be developed, and thus the owners wanted the undeveloped land to remain in the LLC so that liabilities related to the new development activity would be segregated away from the remaining land. A second essential factor is that the sale cannot be between two commonly owned partnerships — one entity must be a corporation (S or C). Third, the sale must be at fair market value (taxpayers cannot inflate the capital gain portion).
An even simpler scenario is the following: What if an investor has held a parcel for 20 years and then teams up with a developer in an LLC to develop it? All of the investor’s income will be tainted by the developer, and turned into ordinary income. This harsh result can be avoided by having the investor sell the raw land prior to development to a new entity owned by both he and the developer — this will allow him to bifurcate his profit into a taxable sale of a capital asset, followed by ordinary business income from the development and sale, which will occur later.
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Copyright © 2007 Michael Hauser
Michael Hauser is a tax attorney with Maddin, Hauser, Wartell, Roth and Heller, P.C. in Southfield, MI, where he specializes in tax planning for owners of small businesses. He is an adjunct professor in the Tax LLM program at Cooley Law School, where he teaches taxation of real estate.
Reprinted with permission. This article is a condensed version of “Avoiding Dealer Status to Obtain Capital Gains” by Michael K. Hauser, published in Real Estate Taxation (WG&L).