Tag Archives: Developer

For Want of a Nail? How Long-Term Capital Gain Eligibility Can Turn on a Single Piece of Paper

An old proverb teaches that the absence of a horseshoe nail can cause the downfall of a kingdom. A recent Tax Court cases suggest a real estate owner’s eligibility for long-term capital gain can turn on something just as trivial:  a single piece of paper.

The Sugar Land case involved real estate businesspersons who, though various entities, held some land for investment purposes and other land for development purposes. During 2008, they decided to abandon development plans for raw land they originally intended to develop. In 2008, they executed an owner resolution expressing their change of intent. Their land holding company subsequently sold most of the property to an unrelated homebuilder in three transactions in 2011 and 2012. The company then sold substantially all the remaining property to related entities in four transactions spanning 2012 through 2016. The related entities developed that land for resale.

The IRS asserted that the 2012 sales should have generated ordinary income instead of long-term capital gain. Despite several factors militating against capital gain eligibility—including nearby development activity by related entities–the Tax Court found that the sales qualified as long-term capital gain. The court identified the 2008 owner resolution as the critical factor showing their intent.

The Sugar Land opinion is a bookend to the Fargo case we discussed in 2015. In Fargo, the Tax Court held that a taxpayer who held land without developing it for over a decade recognized ordinary income on its sale. The court reasoned that the long holding period did not overcome the absence of an owner resolution or other documentation evidencing the abandonment of the owner’s original development plan. The taxpayer could not recognize long-term capital gain.

Lesson learned? Silly or not, documenting the non-development intent for holding raw land can make a big difference in the income tax bill when the property is sold. If you want long-term capital gain, take a few minutes to make sure the owners execute a contemporaneous resolution or governing documents expressing the intent to hold the property for investment, not development. Otherwise you might tell a tale of losing your own financial kingdom, for want of just one piece of paper.

Helpful Resources:

E. John Wagner, II

How to Sell Raw Land or Air Rights to a Real Estate Developer and Receive Back Finished Condominiums Tax-Free

When a land owner sells to a condominium developer, both the land owner and the developer have motivations favoring the developer “paying“ the land owner with finished condominium units instead of cash. Such a transaction reduces the developer’s up-front cash investment while sometimes enabling the developer to use all the land as collateral for senior financing. While more risky than a cash sale, the seller may receive condominium units more valuable than the cash price the seller could realize.

What gets in the way of these transactions?  Often, the seller balks because the seller lacks the cash to pay capital gains tax on the value of the condominium units received back. To alleviate that problem, transactions are sometimes structured as partnership “mixing bowl” co-investments and redemptions, or as combination ground lease-Internal Revenue Code Section 1031 exchange transactions. These structures may defer capital gains tax; however, they also are subject to restrictions and frequently sufficiently convoluted so as to interfere with the developer’s business structure or senior financing.

In some circumstances an alternative sale structure offers a better solution. Under the alternative, the seller takes the positon that the receipt of finished condominiums is exempt from capital gains tax under Internal Revenue Code Section 1038. These same rules exempt a seller from tax when the seller forecloses on a delinquent purchaser on traditional seller financing (in tax parlance, an installment note). Unlike the mixing bowl or combination ground lease-Internal Revenue Code Section 1031 exchange structures, the Section 1038 structure more closely resembles traditional seller financing, making it potentially more palatable to senior development lenders and more simple for all the parties to understand and implement.

To learn more—including understanding scenarios involving air rights rather than raw land—follow this link to materials summarizing all these potential structures originally presented in an American Bar Association Section of Taxation webinar.

Please note that we post these materials with permission from and subject to the copyright of a co-presenting firm, Meltzer, Lippe, Goldstein & Breitstone, LLP.


IRS Continues Push to Prohibit Tax-Exempt Bond Financing for Developer-Controlled CDDs and Similar Political Subdivisions

Real estate developers routinely use tax-exempt bond financing for infrastructure improvements for new communities. That may change soon. IRS perceives abuse in the process, and has proposed regulations making such bonds taxable if the developer controls the issuing governmental body.

Using enabling statutes under state law, a developer can initiate creation of a governmental body with the power to issue bonds secured by the developer’s land.  Although other types exist, Community Development Districts (often called “CDDs”) are the most common governmental body formed this way in Florida.

Such governmental bodies have historically qualified to issue municipal bonds exempt from federal income tax.  Because investors demand a lower absolute interest rate from tax exempt bonds than taxable bonds, these structures allow developers to enjoy a lower financing cost than would otherwise be the case.

The governing officials for such bodies usually are elected through a voting process weighted based on land ownership. In the early phases of development, the developer owns most or all of the land, and therefore controls the governmental body. When the neighborhood is closer to completion–and end-users have purchased lots and other developed property–the developer loses control, and the new property owners oversee the governmental body.

The problem with the IRS proposed regulations is that the developer always controls the governmental body when making the initial infrastructure improvements–such as roads and utility infrastructure–for a community. At that time, there is no community in which end users can buy lots, homes, or other property.  By prohibiting developer control, the proposed regulations could eliminate–or severely restrict–this form of financing.

The IRS is considering  taxpayer comments suggesting an exemption from the new rules for early-stage developments under developer control. This may provide a middle ground that limits abuse, but permits legitimate infrastructure improvements by governmental bodies that are reasonably expected to eventually be controlled by a widely disbursed group of end-user owners. As usual, the devil is in the details. For example, it may be difficult to fit larger, multi-phase communities within such rules. Unfortunately, with these proposed regulations, the IRS has put the burden on taxpayers, rather than itself, to design a workable framework. Comments are due to IRS by May 23.

Here is a link to the proposed regulations: https://www.irs.gov/irb/2016-10_IRB/ar17.html

 E. John Wagner, II

IRS Court Victory in Capital Gains Case May Help More Taxpayers Than it Hurts

Most capital asset classification cases involve the IRS denying lower-tax-rate capital gain treatment.  Many of these cases turn on whether a taxpayer’s activities relating to the asset were minor enough to avoid becoming an active “business” rather than a more passive activity.

A recent case turned that pattern on its head, with a taxpayer claiming a real estate asset he intended to redevelop was a business asset, not a capital asset, so he could deduct a loss on its sale against other ordinary income.  The IRS argued the taxpayer didn’t sell real estate frequently enough to make his activity a business.  The IRS further argued the loss should be a capital loss that is not deductible against other ordinary income.

The Tax Court agreed with the IRS.  In its opinion, notwithstanding the taxpayer’s primary occupation as an employee of a real estate development company,  the Tax Court ignored the possibility that the taxpayer could be in the business of developing property himself.  The court instead focused solely upon whether he frequently personally purchased and sold property.

The taxpayer’s infrequent personal real estate dealings helped the IRS disallow a loss in this case; however, the Tax Court’s reasoning could be beneficial to other taxpayers with gains.  For example, it could help persons who occasionally develop property—such as a spec home–as a non-primary activity in claiming lower-tax-rate capital gain treatment.  In the end, more taxpayers may benefit from this decision than are hurt.

Here is a link to the Tax Court’s Memorandum Opinion in Evanshttp://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=10655

E. John Wagner, II

Real Estate Investor Forced to Recognize Ordinary Business Income Instead of Capital Gain, Despite Holding Property Without Physical Improvement For Over a Decade

Sometimes it’s what you say, not what you do, that matters. A taxpayer learned that the hard way in a recent United States Tax Court decision.

There are numerous court decisions in which a taxpayer acquired property, incurred “soft costs” to entitle the property for future development, and then recognized capital gain (not higher-tax ordinary income) on the sale of the property. In these cases, the taxpayer did not physically improve the property, and the taxpayer by resolution, agreement, prior tax reporting, or other independent means expressed an intent to sell the property before physical improvement occurred. Amongst other factors, the combination of an expressed non-development intent with the actual lack of physical improvement was sufficient to preserve capital gain treatment, and to prevent the taxpayer’s activities from becoming a more active “business” subject to higher ordinary income tax rates. This sometimes has been true even when the taxpayer sells the property to another company with common ownership, which then develops the property.

The recent Tax Court decision emphasizes that the expression of intent is essential to preserving capital gain qualification, even if property is never developed or improved. In the case, the taxpayer originally intended to develop the property. The taxpayer incurred soft costs to prepare the property for development, but then held the property for over a decade without physically improving it. The taxpayer rented and occupied the property as office space, uses usually considered capital gain-qualifying activities. The Tax Court nevertheless held that the absence of evidence the taxpayer abandoned its initial development intent was sufficient to distinguish the case from others in which taxpayers engaged in the same activities, but specifically expressed non-development investment intent to third parties.

While the decision seems harsh, it is a reminder that the characterization of a taxpayer’s activities in partnership or operating agreements, resolutions, business coding on tax returns, and other third-party pronouncements is essential to protecting capital gain qualification, even if a taxpayer never physically develops property.

Here is a link to the United States Tax Court decision in Fargo v. Commissioner:

E. John Wagner, II

Can Developers Recognize Long-Term Capital Gain By Selling Land They Don’t Own? Maybe, at Least in Florida, Georgia, and Alabama

Reversing the US Tax Court, the US Court of Appeals for the Eleventh Circuit recently held that a real estate developer recognized long-term capital gain when he sold contractual purchase rights in real estate, even though the developer previously intended to develop and resell the underlying real estate as condominiums. The Court found that contractual purchase rights could be a capital asset even though the real estate itself would have become ordinary income generating inventory property had the developer closed the purchase contract instead of selling it. As a result, the developer’s effective tax rate was probably reduced by approximately 20%.

The case bolsters some capital gain preservation tax strategies. It does not, however, provide a blank check to lock in capital gain tax rates by trading in contracts rather than land. A few warnings:

First, the circumstances of the sale deviated from the developer’s original plan. While the Court’s reasoning is not entirely clear, the Court observed that the developer did not originally intend to sell the contractual rights. Instead, the developer originally intended to close on the contract, purchase the real estate, and develop condominiums for resale. The tax result could be different if the developer planned all along to sell the purchase contract itself.

Second, the Eleventh Circuit is a federal appellate court immediately below the Supreme Court, with jurisdiction over Florida, Alabama, and Georgia. It is unlikely the Supreme Court will hear this case. While other federal courts with jurisdiction elsewhere might find the Eleventh Circuit’s decision persuasive, they could reach different conclusions. The Tax Court reached a different conclusion in the same case. The Eleventh Circuit’s conclusion is most helpful to taxpayers subject to the Eleventh Circuit’s appellate jurisdiction. Other taxpayers face greater risks relying on the Eleventh Circuit’s decision.

Here is a link to the Eleventh Circuit’s opinion in Long v. Commissioner:

Here is a link to the Tax Court’s decision in the same case, which the Eleventh Circuit reversed on this issue:

E. John Wagner, II

A Proposal to Better Protect Capital Gains for Real Estate Investors Before Development

We have discussed a structuring technique real estate investors use to protect the lower-federal-income-tax-rate-long-term-capital-gain treatment of real estate gains, before property is converted to an active development purpose that creates higher-tax-rate income. The structuring requires property transfers and the use of multiple business entities, which decreases transparency for the government and is difficult for taxpayers to implement.

A “check-the-box” tax election that allows taxpayers to achieve the same tax result would better serve the interests of all involved. I am co-author of a new Florida Tax Review article proposing such an election. Here is a link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2439888

The following provides a broader overview of the structuring technique allowed under current law: Check the Box Bramblett – ABA Tax SEB Committee Presentation

E. John Wagner, II

Protect Capital Gains for Real Estate Investors Before Development

In January we noted a new Tax Court case, Pool v. Commissioner, addressing the boundaries of a structuring technique real estate investors use to protect the lower-federal-income-tax-rate-long-term-capital-gain treatment of real estate gains, before property is converted to an active development purpose that creates higher-tax-rate income. Tax Court Sets Boundaries For Predevelopment Capital Gains For Real Estate Developers

Here is a link to materials from the American Bar Association Tax Section meeting in Washington this month, discussing the case in more detail: Pool v Commr ABA SEB Committee Presentation (May 10 2014)

The following provides a broader overview of the structuring technique: Check the Box Bramblett – ABA Tax SEB Committee Presentation

E. John Wagner, II

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.
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