Capital Gains or Ordinary Income — A Developer's Choice?

By Douglas P. Cushing

A recent tax court case demonstrates how real estate developers, normally subject to ordinary income treatment, can with careful planning take advantage of capital gains rates on sale transactions. Phelan v. Commissioner, T.C. Memo 2004-206, addressed the structure and operating strategies of commercial developers who acquired and then sold off portions of a major residential development parcel but still obtained the benefit of capital gains rates. One 40-percent owner saved $270,000 in taxes on sales of the first 15 percent of its property, which demonstrates the potential benefit of a carefully constructed arrangement like the one in Phelan.

Section 1221 of the Internal Revenue Code essentially excludes from the definition of a capital asset any property held for sale in the ordinary course to customers. This means that a residential real estate developer must treat the profit from lot sales as ordinary income. The case law on this question contains a number of apparently irreconcilable decisions, but focuses frequently on how long the property has been held, who has made the development efforts, whether there was an identified purpose for the property at the time of acquisition, and the nature of the sales efforts. Even an individual who simply develops his own 5 or 10 acres may inadvertently convert himself from a long-term capital gains investor to a developer and face the consequences of higher tax rates.

In the Phelan case, the petitioner, along with his brother and a third party, owned and developed commercial property. They operated through at least two entities that built shopping centers and office buildings. They held identical percentage (40/40/20) ownership interests. Characterized as development, the purchase and sale of land for commercial development would clearly be sales in the ordinary course of business subject to ordinary income tax rates. Characterized as investment, the transaction would be eligible for capital gains rates.

In this instance, the petitioners learned of a 1,050-acre tract for sale, which had significant potential as residential property. The land was subject to a intergovernmental agreement with the county's regional development agency that addressed its future development, as well as a tap-fee agreement with the regional water provider. The development and sales plan that ultimately evolved over a four-year period was as follows:

• Jackson Creek Land Co. (JCLC), a new LLC that was owned in the same 40/40/20 ownership, purchased the 1,050 acres.
• The regional development agency, the nearest city, and the water provider developed a long-range plan for the infrastructure completion, annexation, and development.
• JCLC sold 102 acres to an unrelated third party, which intended to aggressively develop and sell lots.
• The same owners — petitioner, his brother, and their partner — formed another new entity (Vision) to acquire 50 acres, which would subsequently make the basic infrastructure improvements then be sold.
• Because the regional development agency was in financial trouble, the same individuals formed two new entities, one to borrow money and buy bonds and the other to guarantee the loan with which to buy the bonds from the regional development agency to facilitate completion of infrastructure.
• Vision sold the improved 50-acre parcel to an unrelated third party, a residential home builder.

Under these facts, the developers, clearly and admittedly commercial property developers, formed two new identically owned entities essentially as pass-through businesses for purposes of shielding potential liability. They formed two other identically owned companies solely to obtain financing to assist the government players in the development process. Their newly formed entities sold off 15 percent of their original holdings, leaving them with 900 acres from the original acquisition, which had increased significantly in value. This process occurred over a five-year period with infrastructure improvements.

The sales of these properties yielded a substantial profit, and the developers treated this income as capital gains on their returns. The Service strenuously objected, claiming that facilitation of development and subsequent spinoffs by the developer required the other entities to be treated as developers. The tax court rejected that approach to the taxpayers' benefit.

This is not an unprecedented decision; the tax court relied on cases from around the country, but as LLC and LLP entity law develops, we may see that real-world opportunities have jumped ahead of the tax rules.

The key factors for the court were a limited number of sales to outside third parties — only two over five years — and the fact that JCLC never undertook any marketing efforts. The court viewed this as an indication that the owners had held the property for its ultimate long-term value. That they facilitated, and caused, basic development of the property was not seen as sufficient to require them to be treated as residential developers.

Does this suggest that developers can readily convert ordinary income into capital gains? Not in the ordinary sale and development of individual lots, and more particularly, not if a limited number of parcels are quickly sold to other builders, with the developer retaining a portion. Commercial developers and other long-term investors who hold property (such as large lots of 5-15 acres) for an extended time and who can demonstrate significant other regular income sources, may be able to obtain this favorable tax treatment. Structuring the transactions will require good legal and tax advice at the earliest stages because the approach to ownership, marketing, and sales will be critical in determining whether the transaction qualifies for capital gains treatment.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should consult with competent counsel with regard to specific situations.

BACK TO TOP | BACK TO ARTICLE INDEX | PRINTER-FRIENDLY PAGE