Clients selling real estate desire in many cases to pay no tax by structuring their sale as an Internal Revenue Code Sec. 1031 tax-free exchange. 

However, the goal of clients who choose to not do a tax-free exchange is generally to pay tax at lower long-term capital gain rates, 15 percent maximum federal rate, rather than at ordinary income tax rates, 35 percent maximum federal rate.

Additionally, there is a 9.3 percent maximum California state income tax on the sale’s gain, and for tax years beginning after Jan. 1, 2005, there is an additional 1 percent California income tax surcharge for taxable income in excess of $1 million [California Rev. and Tax. Code Sec. 17043(a)].

Long-term capital gain rates apply to a sale of property that is a capital asset held more than one year. The following tax planning strategies will assist clients to achieve favorable long-term capital gain treatment.

Clients who subdivide land or develop land as condominium units, and then sell the subdivided and developed land, normally have their entire gain taxed at high ordinary income tax rates, since the client is classified as a “dealer” selling “inventory” in the form of subdivided lots or condominiums.

Instead of being taxed at ordinary rates on the entire gain, clients can be taxed at lower long-term capital gain rates on the land’s appreciated value by engaging in the following tax plan: 

First: The client, after owning the land in a partnership for more than one year, sells the land to a controlled subchapter S corp in exchange for an installment note. The IRC Sec. 1239 related party rules do not apply to make the gain ordinary because land is not a depreciable asset.

The S corp then develops and subdivides the land, obtains government entitlements, and constructs improvements and condominiums. An S corp, rather than a partnership or LLC, is used as the development entity because IRC Sec. 707(b)(2)(B) states that gain on the sale of property between two related partnerships results in ordinary income if the property is ordinary income property in the hands of the purchasing partnership.

The installment note, because of related party issues, should be on arm’s-length terms and require a payment each time that a lot or condominium sold. The sale to the S corp must be bona fide and shift the burdens and benefits of the land’s ownership to the S corp for the transaction to be recognized for tax purposes (See Phelan, TCM 2004-206). The purchasing S corp must not be classified as an “agent” of the selling partnership for tax purposes.

Second: The installment note should have a specific due date (such as five years or less) and be secured by a deed of trust on the land to appear bona fide for tax purposes. The installment note principal amount limit of $5 million, before interest is paid on the deferred tax liability, should not apply in most cases since this threshold limit applies on a per-partner basis at the partner level [IRC Sec. 453A(b)(2)].

Third: The development activities, such as obtaining subdivision entitlements and constructing the improvements, should be performed by the S corp as the developer—not the selling partnership.

Fourth: Have a “business purpose” for the need of the S corp as the developer, such as the need for different ownership and management by a separate corporation, or the need of a separate developer corporation for liability protection.

Fifth: Part of the gain from the developed project’s sales, which is taxed at ordinary rates, should be allocated to the S corp to properly compensate the S corp for its development activities. The amount of ordinary taxed gain that is allocated to the S corp should be minimized since California imposes a 1.5 percent state corporate level tax on S corp earnings.

For the client to not be classified as a dealer taxed at ordinary rates, and instead receive long-term capital gain treatment, the client could use IRC Sec. 1237, which permits the client to receive long-term capital gain treatment when they subdivide land that is: 

• held for no less than five years;
• subdivided into no more than five lots; and
• not substantially improved by the client. 

Thus, the client can use IRC Sec. 1237 to sell up to five subdivided lots to five individuals and still receive long-term capital gain treatment on the sale of these lots. If more than five subdivided lots are sold, then the gain for years in or after the year in which these additional lots are sold is taxed at ordinary rates to the extent of 5 percent of its selling price [Sec. 1237(b)(1)].

Additionally, IRC Sec. 1237 allows the client who holds land for at least 10 years to receive long-term capital gain treatment where the client only does infrastructure improvements, such as roads and utilities, for that land’s subdivision, but the cost of these improvements cannot be added to the land’s tax basis [IRC Sec. 1237(b)(3)].

Clients who might be classified as “dealers,” and taxed at high ordinary rates because they regularly bought and sold property in the past, still can structure their future sales transactions to be taxed at lower long-term capital gain rates.

Although there is no bright-line test on how to receive long-term capital gain treatment, these clients should consider the following actions: 

• Purchase new property, with the intent to later sell, in a separate single-asset tax entity;
• This single-asset entity should own the newly purchased property for as long as possible to evidence that entity’s intention to hold that property for appreciation and not for resale;
• The legal entity should not be controlled by persons who might be classified as “dealers” in property, and instead should be controlled by persons who would be classified as “investors;”
• The entity’s tax returns should show that the entity was an “investor” and not a developer or dealer of the property;
• Limit any improvements constructed on the property to be improvements for the property’s investment and holding purposes (such as a rental building), and not improvements for the subdivision and sale of the property (constructing roads and utilities for the land’s subdivision appears more like a dealer); 
• The property should not be marketed for sale in multiple lots, nor should it be marketed with a broker immediately after its acquisition or improvement; and
• The property should be sold in the form of one legal lot to one person.

Many times a client, while in escrow to purchase a property, wants to sell the property at lower long-term capital gain rates. To do so, the client must satisfy the one-year capital gain holding period requirement, which states that the property’s holding period commences on the date that the client closes that property’s purchase escrow. 

To satisfy this requirement, the client can sells the property’s escrow purchase contract (rather than selling the property). The escrow purchase contract is a capital asset for tax purposes since it is to purchase land—a capital asset [William T. Gladden, 112 TC 209 (1999); rev’d and rem’d on other issues 88 AFTR2d 2001-5543 (9th Cir., 2001)].

This property’s purchase contract’s one-year holding period began on the date that the contract was signed, not on the date that the property’s purchase escrow closes. Therefore, the client receives long-term capital gain treatment on the contract’s sale so long as the client sells this purchase contract more than one year after the client signed that contract. 

Also, the client can receive conditional cash deposits during the escrow period and not have to pay any tax on these received cash deposits until the sale of the purchase contract closes, at which time the client receives long-term capital gain treatment on these previously received cash deposits.

The client recognizes as income cash deposits only when the client has an unconditional right to retain those deposits. Thus, when the property’s (or contract’s) sale closes, the client recognizes capital gain income. If the sale does not close, any deposit monies retained by the client are taxed as ordinary income [See Jefferson Auto Parking Co., TC Memo 1963-266 and Sec. 1234(a)(1)].

Many times on the sale of property, prior depreciation and amortization deductions will be “recaptured” and taxed at the higher 25 percent federal recapture tax rate. If instead the property is owned in a partnership, this 25 percent tax can be avoided by the redeemed partner by having the partnership redeem the client’s partnership interest, rather than the partnership selling the property, resulting in the client’s entire redemption gain being taxed at lower long-term capital gain rates [Treas. Regs. 1.1(h)-1(b)(3)(ii)]. The recapture gain still remains in the partnership, but the partnership may receive a step up in the tax basis of the partnership’s assets by making a Sec. 754 election.

Clients who construct a building on land which the client has owned for several years may find a buyer before the construction is completed. If the client does sell the land and building during construction and then closes the sale escrow after the building improvements are completed, the building improvements’ one-year capital gain holding period begins only upon those improvements’ date of completion. 

However, where the client has owned the land for more than one year, the land’s sale gain still can be taxed at long-term capital gain rates, even if the building improvements are not completed by the closing of the sale. Additionally, the “cost” of those building improvements that are completed one year before the sale also are taxed at lower long-term capital gain rates [See Russo, 68 TC 135 (1977), and Rev. Rul. 75-524, 1975-2 CB 342].

The client must also evidence that the client intended to hold the property for investment and not for resale. The client should have an appraisal prepared to prove the “cost” of these building improvements that were completed one year before their sale.