Attaining Capital Gains Treatment of Property Transactions: Dealer Versus Investor
Recent Case Law Provides Guidance for Taxpayers Seeking Investor Status

By Frances E. McNair, Michael F. Lynch, and Nicholas C. Lynch

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JUNE 2007 - Notwithstanding the recent downturn in the housing market, real estate values remain close to an all-time high. Because of the current low capital gains rates, many speculative investors are selling large parcels of undeveloped or partially developed real estate. The IRS has sought to tax such sales at the higher ordinary income rates. According to the IRS, if such sales are frequent or substantial, if the property has been improved too much by the seller, or if the seller is merely an “agent” of the buyer, then the IRS will deny capital gains treatment. Whether a seller is deemed a “dealer” or “investor” has been a concern for a long time.

Gain or loss on property held for sale by a dealer is generally treated as ordinary income (loss) for tax purposes, whereas sales of capital assets that are held for “investment” purposes receive capital gain (loss) treatment. No explicit legal standard exists for the determination of dealer status in the sale of property. The problem is so severe that, according to the Fifth Circuit Court of Appeals, “if a client asks you in any but an extreme case whether, in your opinion, his sale will result in capital gain, your answer should probably be, ‘I don’t know and no one else in town can tell you’” (J.D. Byram, CA-5, 83-1 USTC para. 9381, 705 F. 2d 1418). Recent court decisions have led to constructive guidance for taxpayers wishing to frame their selling activities to favor investor status.

It is important to understand the distinction between dealer and investor status. The term “dealer” is widely used to denote one who holds real property for sale rather than for investment purposes. Under IRC section 1221(a)(1), real property will not be considered a capital asset if it is “held by the taxpayer primarily for sale to customers in the ordinary course of a trade or business.” As defined by the Fifth Circuit, “business” means:

The work, notwithstanding disguise in spelling and pronunciation, means busyness; it implies that one is kept more or less busy, that the activity is an occupation. It need not be one’s sole occupation, nor take all his time. It may be only seasonal, and not active the year round. It ordinarily is implied that one’s own attention and effort are involved, but the maxim qui facit per alium facit per se applies, and one may carry on a business through agents whom he supervises (C.P. Snell v. Comm’r, CA-5, 38-2 USTC para.9417, 97 F2d 891).

Therefore, any gain or loss on real property that is held primarily for sale will be treated as ordinary gain or loss. The word “primarily” in this context means “of first importance,” or “principally” [Malat v. Riddell, 383 US 569, 17 AFTR2d 604 (1966)]. If the property is not determined to be held for sale, then it will receive capital gains treatment.

Advantages and Disadvantages of Investor Status

Investor status benefits all taxpayers. Individual taxpayers are subject to a maximum 15% tax rate on capital gains resulting from the sale of property that has been held for a period of greater than one year [IRC section 1(h)]. Although corporations are not privy to the low income tax rate on long-term capital gains, such gains can be used to offset capital losses that otherwise may expire at the corporate level. Certain taxpayers can elect to receive installment sale treatment on the sale of capital assets. Property that is held for investment purposes is eligible for tax-free exchange treatment under IRC section 1031(a)(1). Under IRC section 453(b)(2)(A), with the exception of certain shares of residential lots, dealer sales of real property are ineligible for installment sale treatment and are taxed as ordinary income. Under IRC section 1031(a)(2)(A), such dealer-held property is not eligible for tax-free exchange treatment; a dealer may also be liable for self-employment taxes.

The disadvantage of capital asset treatment relates to taxpayer losses. Individual taxpayers can offset capital losses with current-year capital gains. The first $3,000 of any excess capital loss can be deducted in the current taxable year to offset ordinary income. Any excess capital losses are carried forward indefinitely [IRC sections 1211 and 1212(b)]. Corporate capital losses, however, automatically become short-term and must be carried back three years and then forward for five years. Therefore, when large net capital gains are at stake, investor status is crucial to attaining preferential tax treatment for any taxpayer.

Key Factors Considered

The significant differences between ordinary (up to 35%) and capital (15% or less) gain rates lead most taxpayers to seek capital gains treatment on the sale of real property. It is imperative that the taxpayer plan each transaction in the most advantageous form possible. Factors to consider in determining dealer versus investor status include the following:

  • The nature and purpose of the property acquisition and period of ownership;
  • The length of time the property was held;
  • The reason that the property was held;
  • The nature and extent of any improvements;
  • The extent of developing and subdividing the property, including advertising to increase sales;
  • Prior and current dealings in similar property;
  • The efforts of the taxpayer to sell the property;
  • The number, substantiality, extent, and continuity of the sales (frequency);
  • The use of a business office in the sale of the property;
  • The degree and character of control or supervision that the taxpayer exercises over any representative selling the property; and
  • The time and effort that the taxpayer devoted to the sales.

Although no one attribute clearly determines intent, the frequency and substantiality of the sales seem to be the most important factors. For example, prior case law cites that “the presence of frequent sales ordinarily belies the contention that property is being held for investment rather than for sale” [Bramblett v. Comm’r, 960 F.2d 526, 69 AFTR2d 92-1344 (CA-5, 1992), citing inter alia Suburban Realty Co., 615 F.2d 171, 45 AFTR2d 80-1263 (CA-5, 1980); see also A.B. Winthrop v. Commissioner, CA-5 69-2 USTC para. 9686, 417 F2d 905, and Fraley v. Comm’r, TCM 1993-304].

Examples of Case Law

Because no explicit legal standard exists for the determination of dealer status, the final determination in many cases has been left up to the courts. Past and recent case law lends constructive guidance to taxpayers wishing to frame their selling activities to favor investor status.

In Reese v. Comm’r [615 F.2d 226, 45 AFTR2d 80-1248 (CA-5, 1980)], the Fifth Circuit Court of Appeals held that “a single transaction ordinarily will not constitute a trade or business when the taxpayer enters into the transaction with no expectation of continuing in the field of endeavor.” This ruling was upheld in Paullus v. Comm’r (TCM 1996-419), where a single tract of land was sold to a developer and deemed held for investment, even though the seller had maintained a list of 97 people who were interested in purchasing lots on the property. This “single sale” rule, although helpful, is not a decisive factor in determining investor status (see IRS Information Letter 2002–0013). In Boyer v. Comm’r [58 T.C. 316, 318-325 (1972)], for example, the sellers made various improvements to the land after selling it to their corporation. They had it rezoned, surveyed, and platted, and installed sewers and streets. Although the sellers did not act in their individual capacities in doing so, the courts ruled that the “purchaser’s intent to sell the property was attributable back to the seller,” and the sale was taxed as ordinary income. The IRS realizes that not all improvements are significant, and some (such as soil testing) have not led to ordinary income treatment (see Phelan, TCM 2004-206).

In Byram [705 F.2d 1418, 52 AFTR2d 83-5142 (CA-5, 1983)], the Fifth Circuit Court of Appeals granted capital asset treatment to 22 sales of land made over a three-year period. The relevant factors in the case included the fact that the taxpayer did not initiate the sales, maintain an office, develop the property, or devote a great deal of time to the sales. It appears that there is no limit to the total number of lots that can be sold while maintaining investor status.

Related-Party Transactions

Many land developers use partnerships to buy and hold property while planning the development of the property. When physical development of the property is ready to commence, the partnership usually sells the property to a related corporation. The idea is to receive capital gains treatment on the property sale, followed by ordinary income treatment on the property development and ultimate sale to an outside party. In structuring such a transaction, it is necessary that a corporation serve as the development entity. It is important that the activities of the investment entity and the development entity remain separate.

The choice of entity in which to hold real property is important. A real estate dealer may hold certain property as an investment while simultaneously holding other property for sale to customers in the ordinary course of business. Because the frequency and substantiality of the sales are considered the most important factors in attaining investor status, it is wise to hold each property in a separate entity.

As mentioned, a partnership is the ideal vehicle to buy and hold the investment property. The Supreme Court has held that “the partnership is regarded as an independently recognizable entity apart from the aggregate of its partners” [Basye, 410 U.S. 441, 31 AFTR 2d 73-802 (1973)]. It so follows that any gain or loss at the entity level would be recognized from the viewpoint of the partnership itself rather than the individual partners. Nevertheless, a single-member limited liability company (LLC) may also be used to purchase and hold the investment property. The single-member LLC will be disregarded as an entity separate from the taxpayer unless the LLC elects to be taxed as a C corporation or S corporation [see Treasury Regulations section 301.7701-2(a)]. IRC section 1366(b) states that the character of income to an S corporation is determined at the entity level; therefore, even if an individual is a dealer in land, a capital gain from the sale of land at the entity level will flow through to that shareholder as a capital gain on Schedule D of the respective shareholder’s Form 1040.

Exceptions to entity-level characterization exist. In cases where a partner contributes ordinary-income property that the partnership sells within a five-year period, any gain on the sale of the property is treated as ordinary income [IRC section 724(b)]. A similar provision exists for an S corporation if the purpose of the contribution was to receive capital asset treatment [Treasury Regulations section 1.1366-1(b)(2)].

Under IRC section 707(b)(2)(B), any gain on the sale of property between two commonly owned partnerships will always result in ordinary income if the property is ordinary income in the hands of the purchasing partnership. Because no such limitation exists on sales between commonly owned partnerships and corporations, it is wise to form the selling entity as a partnership and the developing entity as an S corporation. All sales between the two entities should be at fair market value.

In 2002, the IRS released an information letter (2002-0013) discussing the use of the related-party sales method. The letter cited “the magnitude of the seller entity’s pre-and post-transfer activity with respect to the property” as the most important factor in determining the character of any gain or loss from a related-party sale. Other factors included: 1) the length of time between the seller’s purchase and ultimate sale of the land; 2) the seller’s purchase and ultimate sale of other properties; and 3) the seller’s experience and involvement in real estate. Although the letter did not negate capital gains treatment from a related-party sale, it did indicate that the IRS would continue to argue the existence of an agency relationship in certain related-party transactions, an issue that has been the cause of much litigation.

Separate-Entity Case Law

In Brown v. Comm’r [448 F.2d 514, 517, 28AFTR2d 71-5611 (CA-10, 1971)], the seller authorized a parcel of land held in a separate entity to be platted and approved by a local planning commission, and spoke with an engineering company as to where future streets and utilities would be located prior to its sale to a development corporation. The seller’s attorney also initiated the formation of a public works authority in order to construct a sewer system on another tract of land held in the selling entity prior to its sale. The Tenth Circuit Court of Appeals held that the short holding periods of the property (both properties were held for less than a year), the seller’s direct participation in their development, and the sale to a related purchaser constituted dealer status, so any gains from the sale of the properties were to be taxed as ordinary income.

In Ronhovde v. Comm’r [T.C. Memo 1967-243 (1967)], the fact that the selling partnership held only the land at issue for sale and failed to perform any development activities on the property was indicative of a one-time transaction for investment purposes, rather than a sale to customers in the ordinary course of a trade or business, despite the fact that the selling partnership shared a 30% common ownership interest with a publicly traded development corporation.

In Carey v. Comm’r [TCM 1973-197], capital asset treatment was upheld when a taxpayer’s wholly owned real estate development corporation transferred two tracts of land held for sale to two separate partnerships, only to repurchase those tracts within a year. Key factors leading to the court’s decision included: 1) because the taxpayer owned 100% of the real estate development corporation and only 50% of the partnerships, the other partners assumed risk and contributed value to the partnerships; 2) the corporation used “reasonable judgment” in selling the land to the partnerships, because the taxpayer was willing to give up 50% of the profits from the sale of the land; 3) both sales were at arm’s-length prices; 4) the purpose of the partnerships was deemed to be “speculative investment activities”; 5) each partnership was involved in “isolated transactions”; and 6) no physical improvements were made while the partnerships held the tracts of land.

In Bramblett, the Fifth Circuit Court of Appeals awarded capital asset treatment to a related-party sale between an investment entity and a development corporation even though the two entities shared identical ownership. The factors that worked in the taxpayer’s favor included: 1) the selling partnership’s stated purpose was real estate investment; 2) the selling partnership held the property for over three years prior to its sale; 3) the selling partnership did not advertise or hire brokers; 4) the selling partnership did not develop, subdivide, or improve the property in any way; 5) the selling partnership did not maintain an office; 6) the partners spent only a minimal amount of time on the activities of the partnership; and 7) the partnership made no more than four minimal sales prior to the one “substantial” sale of property. The ruling in Bramblett was important in that the courts held that “common ownership of both entities is not enough to prove an agency relationship.”

In Phelan, the Bramblett ruling was tested and affirmed. In Phelan, the taxpayer used an LLC to hold a 1,050-acre parcel of land, of which 46.5 acres were sold to an identically owned development corporation after a period of three years. The development corporation in turn developed the land until it was suitable for residential real estate and then sold the land to an independent builder. Significant infrastructure development activities were performed by a quasi-governmental entity financed by entities related to the LLC, and the LLC itself engaged in various activities, including retaining a soil-testing firm and obtaining preliminary and final site plan approval for development on the property.

In Phelan, the IRS argued that the use of an LLC as an investment entity lacked a specified business purpose, and therefore any gain from the sale of property was ordinary in nature. The court, however, viewed holding the developed real estate in a separate development entity, thereby sheltering the remaining real estate from any action brought against the development company, as a valid business purpose. Factors that led to this decision included: 1) the financing provided by the related entities was on fair market terms; 2) the LLC had no control over the quasi-governmental entity that performed the
significant development activities; 3) the development activities performed by the LLC were too minor to override an investment purpose; 4) the primary activity of the LLC was holding a few parcels of land; and 5) the owners of the LLC were not actively engaged in residential land activity, but rather spent their time in commercial general contracting.

In Wood v. Comm’r [TCM 2004-200, 95 AFTR2d. 2005-2778 (CA-11, 2005)], the Court of Appeals for the Eleventh Circuit confirmed that the taxpayer was not in the real estate business, that the real estate he sold was not business-related, and that he therefore could not take business deductions for the properties at issue. The taxpayer was found liable for income tax deficiencies and penalties for the 1994–1996 tax years.

In Wood, the taxpayer sought dealer status in order to generate ordinary losses, and therefore deducted business expenses on several properties that he claimed were “ordinary and necessary in carrying on his trade or business” [IRC section 162(a)]. The court held that three of the properties that the taxpayer claimed to be held for sale were actually purchased as personal residences, while three were deemed held as vacation properties. With regard to a piece of undeveloped land that the taxpayer attempted to neither develop nor sell over the course of 18 years, the court deemed the property held for investment purposes rather than for sale in the ordinary course of a trade or business. Finally, the court determined that the taxpayer’s investment in a limited partnership that purchased and sold undeveloped land to individuals, real estate companies, and developers did not establish the taxpayer as a dealer, because a partnership is an independently recognizable entity. As a limited partner, the taxpayer did not actively participate in daily operations. Furthermore, over a span of 20 years, the taxpayer had sold only four properties. The court cited this lack of “frequent and substantial” sales as a key indicator that the properties were held for investment purposes rather than for sale [see Major Realty Corp. & Subs. v. Commissioner, 749 F.2d 1483 (11th Cir. 1985)].

Recent Letter Rulings

Taxpayers wishing to minimize the risk of an audit may file a request with the IRS for a private letter ruling. Three such rulings were recently issued to charitable organizations concerned that their real estate attributes may classify them as dealers, thereby triggering unrelated business income tax (UBIT). The factors considered by the IRS in these favorable rulings are helpful in planning to achieve investor status.

In Letter Ruling 200510029, a school for disadvantaged children sold nine parcels of a single piece of farmland that had become suitable for development. The factors considered by the IRS included: 1) the historic use (farming) was related to the organization’s exempt purpose; 2) the parcel was too large to “maximize value” in a sale to a single buyer; 3) multiple sales would allow the seller to control the “pace and type of development”; 4) the proposed buyers would bear the cost of all development activities, including the site plan and improvements, any on- and off-site construction activities, and any costs to plat the subdivision of the lots; 5) no improvement was required to make the property attractive for sale; and 6) the land underwent a significant change in the ability to be used for farming, resulting in a “surplus land” status.

In Letter Ruling 200242041, the taxpayer was a religious school located on the property to be sold. The factors considered by the IRS included: 1) the unused portion of land was not suitable for school purposes; 2) the parcel was too large to “maximize value” in a sale to a single buyer; 3) the organization would not advertise the property as “for sale,” but list it with a Realtor following a period of self-marketing; 4) the organization had no prior history of subdividing real estate; and 5) the charity proposed to build a roadway for necessary access to the land as well as provide drainage, landscape, and trails as required by the township where the land was located. The charity was also required to engage in a subdivision agreement with the town, as the land was to be divided into three separate parcels (see Letter Ruling 200532057 for a similar fact pattern and favorable ruling).

In Letter Ruling 200530029, a private foundation that had been unable to sell parcels of unimproved land upon acquisition from its founder (including from the founder’s estate), due to a depressed real estate market, sought to sell the land during a real estate upswing. The factors considered by the IRS included: 1) in aggregate, the parcels were too large to “maximize value” in a sale to a single buyer; 2) zoning changes and significant property tax increases made it unfeasible for the foundation to continue ownership; 3) the parcels were to be divided into lots no smaller than 20 acres each; 4) a maximum of two sales per year over 20 years would ensue; 5) a passive marketing approach would be used in which the foundation would attempt to sell through prospectuses sent to interested parties; 6) all parcels were sold to developers; and 7) the foundation performed preliminary engineering and land-planning activities to determine how to maximize the value of its investment.

Other Relevant Factors

These three letter rulings, together with recent court decisions in Bramblett, Phelan, and Wood, have shed favorable light on a taxpayer’s ability to attain investor status (capital asset treatment) through a related-party transaction. The important factors that emerge include the existence of properly documented arm’s-length sales prices of property sold to a development entity, and documenting a specific business purpose for a related-party transaction. In Bramblett, the Fifth Circuit determined that a specific business purpose existed, all transactions were at arm’s-length, all business and legal formalities were observed and properly documented, and the partners bore the risk that the land might not appreciate.

The installment method, as used in Bramblett, is applicable to related-party transactions, and could be used to defer large capital gains to future tax years. Under IRC section 453, gain on the sale of nondealer (investment) property to an unrelated or related party using seller financing (with interest-bearing notes) will be recognized as payments of principal are made. The seller can no longer, however, defer any gain on the sale if the related-party purchaser resells the property within two years [IRC section 453(e)]. It is wise to finance the development corporation with both debt and equity to ensure that it does not appear thinly capitalized, where any installment sales would be disregarded if the debt were reclassified as equity. If installment sale treatment is deemed inapplicable upon an audit, then the selling entity will have to pay back taxes, plus interest and any penalties that are assessed, at ordinary income tax rates.

IRC section 1237 (and Treasury Regulations section 1.1237-1) provides a safe harbor enabling a taxpayer, under certain circumstances, to receive capital asset treatment on the sale of land that has been owned for at least five years. The specific provisions of the safe harbor are detailed in subsections (a), (b), and (c) as follows: If a taxpayer other than a C corporation holds a tract of land for investment purposes for at least five years, and sells any lot or parcel within that tract, and no substantial evidence exists to suggest that the taxpayer held the land for sale (other than subdividing and/or selling activities), those activities will be ignored and the land will not be considered dealer property. IRC section 1237 was enacted to provide relief from dealer status to an individual who is not in the real estate business but owns a tract of real estate that must be subdivided in order to generate a reasonable profit. A “tract” is defined as a “single piece of real property,” which includes two or more contiguous pieces or would-be contiguous pieces if it were not for an intervening railroad, stream, or road.

The presence of one of the following four facts will not amount to substantial evidence that the property is held for sale: The taxpayer: 1) holds a real estate license; 2) has acted as a salesman for a dealer; 3) has sold other real property; or 4) has owned other vacant land without trying to sell it. The presence of more than one of these four facts will amount to substantial evidence. If the land is inherited, the five-year holding period is not necessary. The tract of land must have never been held for sale, and in the year of sale the taxpayer must not have held any other real property for sale. Furthermore, “no substantial improvement that substantially enhances the value of the lot or parcel sold” can be made by the taxpayer, certain lessees, government entities, or a related party if that improvement causes an increase in value of greater than 10%. Substantial improvements include utility lines, hard-surface roads, and buildings. Insubstantial improvements include building and operating a temporary field office, “surveying, filing, draining, leveling, and clearing operations, and the construction of minimum all-weather access roads.” “Water, sewer, or drainage facilities or roads” are not considered substantial improvements if the tract has been held for at least 10 years, and if the taxpayer can prove that those improvements were necessary to make the lots marketable. Taxpayers must exclude such improvements from the property’s cost basis, however, thereby increasing the amount of taxable gain.

The safe harbor applies to the first five lots or parcels sold from the tract of land, after which gain from all future sales will be taxed as ordinary income to the extent of 5% of the sales price. To the extent that IRC section 1237 cannot be used, the standard land-dealer rules apply.

Recent Decisions Illustrate Opportunities

In the absence of an explicit legal standard for determining investor status in the sale of long-term real property, taxpayers must still turn to the courts for guidance. Recent case law provides favorable opportunities for taxpayers trying to frame their selling activities to favor investor status.

Taxpayers should not overlook the practical steps discussed above when setting up a related-party transaction. For example, if one is using a partnership as the selling entity, the fact that the partnership is formed for investment purposes to acquire and hold property for appreciation in value should be explicitly stated in the partnership agreement. The name of the partnership should include “investors” rather than “developers”; the business activity listed on Form 1065 should be “investment” not “sales” or “development”; the property should not be classified as a business asset or inventory on the balance sheet but as a land investment; and, to the extent possible, each investment property should be held in a separate entity. The selling entity should refrain from actively taking part in any development activities. Furthermore, taxpayers should accurately track their time spent on each entity, in an effort to minimize any potential selling efforts. Finally, taxpayers should neither advertise the sale of investment property nor retain brokers to sell the property.

One major drawback to holding investment property is having the property appreciate without being able to develop it. Taxpayers can potentially create appreciation by developing the property in sections or phases. For example, a partnership could sell 20% of the land to the development corporation, upon which development of the transferred property may significantly increase the value of the remaining undeveloped property. The court upheld such a sale in Phelan as a valid business purpose, enabling the selling partnership to either develop the retained property or sell it to another party at a future date, ensuring investor status.

With no guidance from the IRS in determining investor-versus-dealer status, taxpayers are left to follow the subjective factors based on the “totality of circumstances” and a factual determination on a case-by-case basis. Several factors are frequently considered by the courts in determining whether the sale of property receives dealer or investor status. Of those factors, the frequency and substantiality of sales is the most important. With proper tax planning, the significant factors can be arranged to benefit a taxpayer. Advisors should keep in mind that because a taxpayer’s intent with regards to such property may change following its acquisition, the intent at the time of sale and the time of acquisition may also be judged.

Taxpayers assume a degree of risk in claiming investor status because such related-party transactions receiving capital gains treatment are frequently contested by the IRS. Taxpayers wishing to minimize the risk of an audit may seek a private letter ruling from the IRS. If a client asks a tax advisor whether his sale will result in a capital gain, the better reply is: “I do know the answer that no one else in town can tell you.”


Frances E. McNair, CPA, PhD, is a professor of accounting at Mississippi State University in Starkville, Miss.
Michael F. Lynch, JD, CPA, is a professor of tax accounting at Bryant University in Smithfield, R.I., and a practicing attorney in Providence, R.I.
Nicholas C. Lynch, MSA, is a doctoral candidate in accounting at Mississippi State University.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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