Protecting capital gains on real estate development to help maximize after tax rate of return

Currently, there are many real estate owners seeking techniques to maximize their rate of return on their real estate holdings. Some alternatives under consideration are to continue to hold, develop, sell, or jointly develop with a partner the real estate. Each of these alternatives has their own risks and rewards but evaluating the tax considerations will help maximize your after tax rate of return. The general rule is if a real estate owner sells real estate at a gain, then that gain will be taxed at the federal capital gains rate of 15%, provided that the person is not a dealer in real estate. On the other hand, if that same person substantially enhances the real estate, and then sells the real estate, then the real estate owner will probably be taxed on that income as ordinary income; ordinary income is taxed up to 35%. Therefore, protecting the 20% capital gains treatment is an important consideration on your after-tax rate of return. For example, if you purchased raw land in the Hamptons 15 years ago and you paid $1 million for the land, today, it may be worth $3 million. If you sell the Hampton land for $3 million, your gain will be $2 million. After the federal capital gains tax of 15% and NYS income tax of about $450,000, you can have $2.5 million after the sale. Not bad for a return, but if you developed that property you may be able to realize significantly more money. Even better, if a developer puts up the money to develop the property and shares with you the greater appreciation. First rule: Avoiding dealer status If you sell or market real estate with any frequency, then you risk being classified as a real estate dealer by the IRS. If that happens you would lose the benefit of the federal capital gains tax rate of 15%. Generally, capital gains are not offered to real estate dealers as they are offering property held by taxpayers primarily in the ordinary course of their trade or business. Taxpayers have argued that they are not dealers by either; they are not in the trade or business of selling real estate or if they are, claiming that a particular tract of property was not for "primarily for sale." Dealer status involves a pattern of frequency and continuous sales. If a real estate owner improves, subdivides, or sells or disposes land with frequent and continuous sales activity, then it is difficult to avoid being classified as dealer status. In contrast, if a real estate owner sells land on an isolated situation without any significant marketing activities, then the real estate owner should be able to get capital gain treatment. If the real estate development route is decided, then a very good tax planning technique is for the owner to sell the Hamptons land in bulk to an entity controlled by the owner and have that entity perform its dealer status. This technique should be able to protect the capital gains on the pre-development appreciation. In addition, this technique makes good business sense as real estate development carries more business risk and that risk is transferred to a separate entity. Some owners may want to sell the land to the development company at a higher price attempting to convert future ordinary income into capital gains. It can be believed that you risk the IRS converting the entire gain as ordinary, therefore, an independent appraisal should be obtained to support the selling price to the development company. Many real estate owners have been using LLCs for their real estate developing, but capital gains to your LLCs will not be allowed on your sale. Under tax law, gains on the sale of property will be ordinary income if the sale is to a LLC in which the real estate owns more than 50% of the capital or profit interests and the property is not a capital asset of the LLC. Therefore, you will need to conduct your real estate development in a corporation to protect your pre-appreciation gain. If the development company operates as a C corporation, any profits will be taxed at the entity level and again taxed to the shareholders when the cash is distributed. This creates a double tax for the owners. Choosing an S corporation as opposed to a C corporation can avoid the double tax on the development income. There are other financing considerations that can be taken into account to ensure that any pre-appreciation is treated as capital capitals. Therefore, choosing the proper entity can ensure that capital gains can be obtained if real estate owners chose the proper structuring. Barry Sunshine is a tax partner at Grassi & Co., Jericho, N.Y.