In general, real estate developers and real estate investors do not receive capital gain treatment when they sell a parcel of land, because the IRS views land owned by such taxpayers as “inventory” rather than as investment property. However, under the right circumstances and by carefully structuring the initial purchase and eventual sale of the parcel to a related entity developer, a taxpayer may convert what would have been ordinary income to capital gain.
Consider the following scenario: Three taxpayers, who held interests of 40%, 40%, and 20%, organized a limited liability company (“LLC”). In 1994, LLC purchased approximately 1,000 acres of vacant land with the intent to hold the property so that it would appreciate in value as residential property. In 1998, LLC sold part of the property to an S corporation (“S Corp”) that had identical ownership as LLC. S Corp built and sold houses on the parcels. The taxpayer reported his share of the proceeds of the sale to S Corp as capital gains, but the IRS contended the sale proceeds should have been treated by the taxpayer as ordinary income.
The Tax Court decided in favor of the taxpayer. In so doing, the Tax Court reviewed three factors. First, the court held LLC purchased the property for investment. Second, the court held that LLC’s activities in preparing the property for sale did not constitute the conduct of a trade or business, and the court refused to attribute to LLC the activities of S Corp in preparing the property for development. Finally, the Tax Court held that the sale of the property to a single entity rather than by a series of sales of many parcels to different owners or developers supported the taxpayer’s claim that LLC held the property for investment and was not indicative of a real estate development business.
If you would like to discuss the structuring of the purchase of investment real estate to qualify for capital gain treatment, please do not hesitate to contact us.