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CAPITAL GAINS ARE BACK -- TAX PLANNING FOR REAL ESTATE TRANSACTIONS UNDER THE TAXPAYER RELIEF ACT OF 1997 By Steven Toscher, Esq. and Stuart Simon, Esq. © January, 1998
Preferential tax treatment for capital gains has come and gone over the years. Between 1934/5 and 1986, taxpayers were permitted to deduct a portion of their capital gains in determining their income through the so-called "Section 1202 deduction." For tax years starting in 1978, when the maximum regular tax rate was 70%, the Section 1202 deduction was 60% of the capital gain, yielding an effective capital gains tax rate of 28%. When the maximum tax rate on ordinary income was reduced to 50% starting in 1981, the capital gains tax rate was effectively reduced to 20%.
With the lower capital gains tax rate under TRA 97, comes - - not surprisingly - - a new level of complexity. The complexity is especially evident in the real estate area where there are now special rules and limitations that reduce the capital gains tax benefits for depreciable real property. The holding periods for capital gain treatment have been changed by TRA 97. The long-term capital gains rate of 20% will generally apply only if the taxpayer holds the asset more than 18 months./10 A new "mid-term gain" rate of 28%/11 has been created for assets held more than 1 year, but not more than 18 months./12 Assets held for not more than 1 year will be "short-term capital gains" and taxed at the same rate as ordinary income./13 The new three-tier holding period system is a departure from the prior system, where capital gains were either long-term or short-term.
The Tax Technical Corrections Act of 1997/19 is pending before the Congress. Among the proposed changes are provisions that will provide for a netting approach for gains and losses of the 28% type (collectibles, certain small business stock, mid-term holdings), 25% capital gains (depreciable real estate), and 20% capital gains (long-term holdings)./20 The Internal Revenue Service has recently issued Notice 97-59,/21 reflecting the pending technical corrections and Announcement 97-109,/22 describing the changes in the reporting requirements for capital gains.
When a pass-through entity, such as a partnership or limited liability company is involved, the determination of whether its gains are capital in nature is made at the entity level. Whether a capital gain is a long-term, mid-term or short-term will be determined by the holding period of the pass-thru entity, not the holding period of the individual taxpayer./23 With the decreased tax rate for capital gains, increased emphasis will be placed upon whether a transaction will receive capital gain treatment. This will require practitioners to consider traditional "capital gain vs. ordinary income" issues they have not had to consider for a number of years. A threshold issue in real property transactions is whether the taxpayer is considered a "dealer" in real property. This may arise when an owner of real property decides to develop and sell his property. If the taxpayer is considered a "dealer," the real property will be considered inventory or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business, and will result in ordinary income - - not capital gain treatment./24 Whether real property is held "primarily" for sale to customers is a question of fact. The Supreme Court has interpreted the word " primarily" to mean "of first importance" or "principally."/25 Determination of the dominant purpose requires an evaluation of the taxpayer's intent when the property was acquired and throughout the period the property was held. Important factors include the frequency and continuity of real property sales in earlier and later years, the volume of sales, the amount of advertising, the degree and scope of improvements, the degree and scope of subdivision and development, the ratio of cost of improvements to the original investment and the time lapse between acquisition and the commencement of development./26 If the taxpayer is essentially "passive" in his real estate activities, the activities will not constitute a trade or business and gains will be subject to the capital gains tax rate. Passivity is established through a facts and circumstances analysis./27 The factors include: (1) number, frequency and continuity of sales; (2) extent of improvements; (3) manner of acquisition; (4) nature and extent of promotional activities; (5) use of agents; (6) length of holding period; and (7) proportion of income from real estate activities./28 Even a taxpayer who is a dealer may qualify for capital gains treatment for investment transactions. Investment and dealer properties can be segregated to improve the likelihood of securing capital gain treatment on the sale of the properties earmarked as investments. If the taxpayer is careful in segregating the investment assets, capital gain treatment may be secured./29 However, segregation by itself is not conclusive. The surrounding facts and circumstances must substantiate the reality of the segregation. Lengthy holding periods, the lack of improvements, subdivision or advertising, and sales from unsolicited offers tend to support the characterization of investment property./30 The risk of dealer characterization may be minimized by a "change of plans" that eliminates the intent to sell the property to customers in the ordinary course of business. For example, a developer may acquire a large parcel of real property with the intent to subdivide and develop the property for sale only to run into events that force a change in plans. Financial conditions may force a developer to abandon its development plans./31 A developer may be unable to sell the properties and will rent the properties prior to sale./32 The change in circumstances and intention should be fully documented./33 The importance of whether a taxpayer is a dealer or investor, and the difficulty of a taxpayer engaged in dealer type activities achieving capital gain treatment, is illustrated by the case of Jarret v. Commissioner./34 In Jarret, the taxpayer, an attorney, and another individual acquired an unimproved parcel of land. At about the same time, they organized a corporation to operate a real estate development, sale and construction business. The taxpayer also filed a Schedule C for his own real estate "development" business. The parcel was divided into two portions for development purposes, Frontland, which was on a public road, and Backland, which did not front on any public road. Frontland, which did not require any governmental approval for subdivision, was subdivided into 21 lots which were sold. Backland could not be developed without governmental approval. It was intended that approval for the subdivision be obtained for Backland and that it be sold as a single parcel to a developer. Steps were taken in order that the subdivision be approved. Upon approval of the subdivision, Backland was sold to a developer. The taxpayer reported the gain from the sale of Backland as capital gain. The Tax Court found that the taxpayer was in the real estate business and had sold Backland to a customer in the ordinary course of business. As such, Backland was not a capital asset and the taxpayer realized ordinary income on its sale under Section 1221(1). An investor may undertake limited subdivision activities of real property and still qualify for capital gain treatment. If the requirements of Section 1237/35 are met, the proceeds from the sale of the first five lots or parcels during the taxable year are treated as amounts received from the sale of capital assets./36 All sales made during or after the year in which the sixth lot is sold are subject to a "5 percent rule." Under the 5 percent rule, 5 percent of the selling price of the sixth and subsequent sales are treated as ordinary income, with the balance being treated as capital gain. The seller may apply selling expenses entirely against the ordinary income portion of the amount realized; thus, only 5 percent of the proceeds (less selling expenses) is reportable as ordinary income. The Code sets forth a number of requirements for Section 1237 capital gain treatment. First, the taxpayer may not have held either the tract, or any lot or parcel thereof, primarily for sale to customers in the ordinary course of business./37 Second, no substantial improvements by the taxpayer are allowed that enhanced the value of the lot or parcel sold./38 Substantial improvements include the installation of hard surface roads or utilities, such as sewers, water, gas, or electrical lines./39 The regulations provide a safe harbor that allows for improvements that increase the value of the lot by 10% or less./40 Third, unless the lot or parcel was inherited, it must have been held by the taxpayer for a period of 5 years./41 Another issue to consider now that capital gains are back is the limitations on related party sales. Under Section 1239, any gain recognized from the sale or exchange of property, directly or indirectly, between "related persons,"/42 is treated as ordinary income if the property is depreciable in the purchaser's hands./43 Ownership will be attributed to the taxpayer under the rules of Section 267./44 This includes ownership by the taxpayer's spouse, ancestors, lineal descendants, brothers and sisters, and proportionate interests in trusts, estates, partnerships and corporations. The purpose of Section 1239 to deny capital gain treatment on sales in which the related taxpayer would receive a stepped-up basis for depreciation purposes, while the sale would be taxed at the lower capital gains rates. There is a similar provision for transactions involving partnerships. Under Section 707(b)(2), gain recognized from the sale or exchange of property, directly or indirectly, in a "related partnership transaction," is treated as ordinary income if, in the transferee's hands, the property is not a capital asset as defined in Section 1221./45 This includes depreciable real property used in a trade or business. A "related partnership transaction" is a transaction between a partnership and a person owning, directly or indirectly, more than 50% of the capital interest of the profits interest in the partnership,/46 or between two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital interest or the profits interest./47 The attribution rules of Section 267 apply in determining the ownership of a capital or profits interest in a partnership./48 Like Section 1239, the purpose of this limitation is to prevent a controlling partner from transferring depreciable business property to the partnership at capital gain rates, while allowing the partnership to recover the full cost through depreciation deductions which offset ordinary income. A tax planning issue that was common in pre-1986 Tax Reform Act transactions and that will likely be revived under the new law is the attempt to achieve a capital gain even where the seller will be involved in the future development of the property. The basic technique was an installment sale of the real property to a new entity. Gain recognized by the seller would be treated as capital gain. The new entity, in which the seller would have an interest, would develop the real property and recognize ordinary income on its profits. An entity would be selected that would provide for income to pass through to the owners without double taxation, such as an S corporation, partnership or limited liability company ("LLC"). Two critical issues are present in such a transaction. First, the seller's interest in the development entity must be limited so that the development entity is not considered a controlled entity, especially if the related party rules of Section 1239 or Section 707(b)(2) might apply. Thus, the seller must own less than a 50% interest in the S corporation, partnership or LLC used as the development entity -- considering the applicable ownership attribution rule. The sale to the development entity must be arms length. The sales price must be at fair market value and an appraisal should be obtained to support the valuation. The installment note must have terms that would be found in a standard commercial instrument. These terms include a fixed payment schedule, a reasonable interest rate, and security. If the proper steps are not taken, the IRS could challenge the sale as a "sham" transaction, which could result in the seller being treated as a "dealer" and recognizing the gain from the property as ordinary income./49 In evaluating a taxpayer's ability to generate capital gains from a sale of real property, the potential recapture of Section 1231 losses must also be considered./50 Code Section 1231 allows a taxpayer to claim ordinary losses on certain depreciable real property used in a trade or business - - such as rental real property. The recent real estate recession resulted in many taxpayers taking Section 1231 losses on sale of rental properties. A taxpayer who has a net Section 1231 gain (excess of Section 1231 gains over Section 1231 losses) for a the tax year must review the five preceding tax years for possible recapture of net Section 1231 losses for such years./51 The taxpayer must treat the current year's net Section 1231 gain as ordinary income to the extent of the amount of unrecaptured net Section 1231 losses the prior five year period./52 Taxpayers -- particularly California taxpayers - -surely remember the old saying that "what goes up must also come down." If real estate is a capital asset, any loss with respect thereto will be a capital loss./53 If a taxpayer has a net capital loss, the maximum loss amount that the taxpayer can deduct in a single year is $3,000. Capital characterization of a transaction is generally a tax loser when losses are involved. Investors reviewing their portfolio may again be considering real estate in light of the recovery of the California market and the preferential capital gains tax rate. While a real estate investment can have its headaches and significant risks, the opportunity to increase one's investment yield will be an inducement to some. As set forth in the example on this page, [Side Bar] an investment in an apartment building, even assuming a modest growth rate of 2 percent per year, can produce a significant after tax investment return over a five year period - - approximately 15.9% average per year - - as a result of the leverage employed in the real estate purchase and the preferential capital gains rate. This should be compared to the after tax investment yield of 3.6 percent of a 6 percent, but safe, U.S. Treasury Bond. The example is not to suggest an investment in real estate instead of Treasury Bonds; but only to point out that the combination of depreciation deductions, leverage and the preferential capital gains rate is a tool for increasing after tax investment returns. The changes in the capital gain rules in TRA 97 should provide incentives for real estate investment and capital gains tax planning for real estate transactions. Transactions must be considered with great care to avoid the numerous traps that could result in the taxpayer receiving ordinary income rather than the capital gains. Capital gains are back and tax professionals once again have their work cut out for them. _______________________ 1. P.L. 105-34. References to "Section" or "§" refer to the Internal Revenue Code of 1986, as amended by TRA 97. 2. The provisions of TRA 97 do not provide the capital gain benefits for corporate taxpayers. As of the present date, the State of California has not enacted a capital gains tax rate reduction. 3. A capital gains tax rate of 10% is provided for noncorporate taxpayers in the 15% tax bracket. I.R.C. §1(h)(1)(D). 4. Prior to TRA 97, the differential between the maximum individual rate, 39.6%, and the tax rate for capital gains, 28%, yielded a 29% savings. 5. Section 117(a) of the Revenue Act of 1934, P.L. 73-216. 6. P.L. 99-514. 7. A new § 1202 was added by P.L. 103-66 for the limited purpose of allowing a 50% exclusion for gain from certain small business stock. 8. P.L. 101-508, the Omnibus Budget Reconciliation Act of 1990. The maximum capital gains rate was a change from the prior treatment of capital gains, as the § 1202 deduction was not restored. 9. P.L. 103-66, the Omnibus Budget Reconciliation Act of 1993. 10. For assets sold before July 29, 1997, the long-term capital gains rate will apply to assets held more that 12 months. 11. The mid-term rate will apply to gains recognized before May 7, 1997. The mid-term rate is the same rate as the pre-TRA 97 maximum capital gains tax rate. 12. I.R.C. § 1(h)(8). 13. A lower capital gains rate was adopted for qualified 5-year gains after December 31, 2000. § 1(h)(2). 14. House Committee Report No. 105-148, to P.L. 105-34, ___ U.S. Code and Cong. News ____. 15. I.R.C. § 1(h)(4)(A) and (b)(5). 16. I.R.C. § 1(h)(1)(B) and 1(h)(6). 17. I.R.C. § 1250. 18. I.R.C. § 55(b)(3). 19. H.R. 2645. 20. H.R. 2645 § 311, amending § 1(h). 21. I.R.B. 1997-45, Nov. 10, 1997. 22. Id. 23. I.R.C. § 1(h)(10)(B) and 1(h)(11). 24. I.R.C. § 1221(1). 25. Malat v. Riddell, 383 U.S. 569, 572 (1966). 26. For a detailed discussion of the factors, see Robinson, Federal Taxation of Real Estate, ¶ 11.06[1][a]. 27. Adam v. Commissioner, 60 T.C. 996, 1000 (1973); Starke v. Commissioner, 312 F.2d 608, 609 (9th Cir. 1963). 28. Adam, 60 T.C. at 999. 29. Pritchett v. Commissioner, 63 T.C. 149 (1974); Westchester Dev. Co. v. Commissioner, 63 T.C. 198 (1974). 30. Schueber v. Commissioner, 371 F.2d 996 (7th Cir. 1967); Pasadena Inv. Co. v. Phinney, 223 F. Supp. 639 (D. Tex. 1963). 31. Lomas & Nettlecon Financial Corp. v. United States, 486 F. Supp. 652 (N.D. Tex. 1980). 32. Bradley v. Commissioner, 26 T.C. 970 (1956). 33. In Walter K. Dean Estate v. Commissioner, T.C. Memo. 1975-137, the Tax Court indicated that while a change of circumstances is important evidence, changed intent may be found by reference to other factors, such as the property being unsuitable for use in the taxpayer's real estate development business. 34. T.C. Memo. 1993-516. 35. The Small Business Job Protection Act of 1996, P.L. 104-88, extended the statutory capital gain rules of I.R.C. § 1237 to S corporations. 36. I.R.C. § 1237(b)(1). The sale of two or more contiguous lots sold to a single buyer in a single sale are counted as only one parcel. Treas. Reg. § 1.1237-1(e)(2)(i). 37. I.R.C. § 1237(a)(1). 38. I.R.C. § 1237(a)(2). 39. Treas. Reg. §1.1237-1(c)(4). However, if the lot or parcel is held by the taxpayer for a period of ten years, no improvement is deemed a substantial improvement if certain requirements are satisfied and an election is filed that the taxpayer will make no adjustment to the basis of the property on account of the expenditures for such improvements. I.R.C. § 1237(b)(3); Treas. Reg. § 1.1237-1(c)(5). 40. Treas. Reg. § 1.1237-1(c)(3)(ii). 41. I.R.C. § 1237(a)(3). For purposes of determining the length of the holding period, tacking is permitted. Treas. Reg. § 1.1237-1(d). 42. Related parties include: (1) a person and any corporation of which more than 50% of the value of its outstanding stock is owned, directly or indirectly, for or by that person(1); (2) a person and any partnership in which more than 50% of the capital interest or profits interest is owned, directly or indirectly, for or by that person(2); (3) two corporations which are members of the same controlled group(3); (4) a corporation and a partnership of the same person owns more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest or the profits interest in the partnership(4); (5) an S corporation and another S corporation if the same person owns more than 50% in value of the outstanding stock of each corporation(5); (6) an S corporation and a C corporation if the same person owns more than 50% in value of the outstanding stock of each corporation(6); (7) a taxpayer and any trust in which the taxpayer or the taxpayer's spouse is a beneficiary, unless the beneficiary's interest in the trust is a remote contingent interest(7); and (8) a taxpayer and an executor of an estate in which the taxpayer is a beneficiary of such estate(8). I.R.C. § 1239(b), (c), (d). 43. I.R.C. § 1239(a); Treas. Reg. § 1.1239-1(a). 44. I.R.C. § 1239(c)(2) (reference to § 267(c), other than paragraph (3) thereof). 45. Treas. Reg. § 1.707-1(b)(ii). 46. I.R.C. § 707(b)(1)(A); Treas. Reg. § 1.707-1(b)(1)(i). 47. I.R.C. § 707(b)(1)(B); Treas. Reg. § 1.707-1(b)(1)(i). 48. I.R.C. § 707(b)(3); Treas. Reg. § 1.707-1(b)(3). 49. Bramlett v. Commissioner, 960 F.2d 526 (5th Cir. 1992), reversing T.C. Memo. 1990-296. 50. I.R.C. § 1231(c). 51. I.R.C. § 1231(c)(2). 52. I.R.C. § 1231(c)(1). 53. If the real property can be characterized as property used in a trade or business, which would include rental property, the real property would be considered Section 1231 property. As Section 1231 property, a taxpayer may deduct as an ordinary loss the excess of § 1231 losses over § 1231 gains. I.R.C. § 1231(a)(2). |