Tax Court Sets Boundaries for Predevelopment Capital Gains for Real Estate Developers

A recent Tax Court case, Pool v. Commissioner, is the first court opinion in many years describing the limits of a popular capital gain tax planning technique used by real estate investors and developers.

Some real estate project legal structures enable investors to recognize a mix of long-term capital gain and ordinary income for Federal Income Tax purposes. This lowers the project’s total tax rate because long-term capital gain is taxed at a substantially lower rate (usually about 20%) than ordinary income (up to 39.6%).

Pool v. Commissioner, a Tax Court opinion issued January 8, 2014, describes the limits on these structures. The Tax Court’s reasons for disallowing long-term capital gain treatment included: insufficient justification for inter-company sale price valuations; unclear documentation regarding title transfers; utility and other improvements made directly by the investment entity; and the internal taxpayer documentation which was inconsistent with the tax position.

The Tax Court opinion can be found here: https://www.ustaxcourt.gov/InOpHistoric/PoolMemo.Goeke.TCM.WPD.pdf

The case demonstrates that IRS can successfully challenge a structure on the wrong facts. It also demonstrates that a court has discretion to determine the most important facts relating to these structures.

In the coming weeks experts will send out alerts and “how many angels can dance on the head of a pin” analyses about this case. In our opinion, the bottom line is that the case highlights mistakes to avoid, but does not bring into question the tax law behind these structures.

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037