Refer to “The 5” – Characterization of Development Gains and Losses
Originally published on February 20, 2014
Updated on October 30th, 2023
The sale of land poses a unique challenge in determining the character of the gain or loss on the sale. Land held as inventory in the taxpayer’s trade or business is considered an ordinary gain or loss while land held as an investment (capital asset) is considered a capital gain or loss. While the distinction between the two characterizations can be finite, the impact can be significant.
Ordinary income is taxed at the standard marginal rates. While the lowest ordinary income tax bracket is 10%, the highest bracket is a painful 37%. The brackets are marginal; meaning each additional dollar that is earned above each threshold is taxed at that brackets rate.
Capital gains tax rates, on the other hand, range from 0% to 20%, again depending on the level of income for the taxpayer. Because of the difference in rates, the general preference is to pay tax on capital gains rather than ordinary income.
Capital losses, however, are generally limited to the lesser of capital gains or $3,000, with excess losses carried forward indefinitely. Ordinary losses (assuming there are no additional limitations such as basis or passive activities) are deductible in full in the year that they are incurred with no such limitation. Because of the difference in loss limitations and the differential in tax rates that the loss offsets, the general preference is to incur an ordinary loss rather than capital loss.
Anytime there are facts and circumstances to consider and a potential range of tax rates from 0%to 37%, there is an opportunity to minimize the tax burden provided that the most optimal outcome can be supported and has basis in the tax law. A recent court case highlights the risk of making the wrong decision about the characterization, but also sheds light on five criteria that can be used to take a well thought out position.
FACTS OF THE CASE
In the recent court case Cordell D. Pool et al. v. Commissioner, the Federal Tax Court ruled that the taxpayers/partners and shareholders in a commonly controlled development corporation and real estate partnership incorrectly characterized the sale of land as long-term gain rather than ordinary partnership income.
In the case, the real estate partnership purchased a tract of land and entered into an agreement with the development company to sell the land in phases. While the agreement required the development company to complete the infrastructure, there was conflicting documentation which listed the real estate partnership as the developer of the land.
The court held that the property was being held for sale to customers (i.e. inventory) versus acting as an investment. The Tax Court found that the partnership:
• Appeared to have made real estate sales to customers other than the real estate company
• Made and paid for improvements to property
• Charged an inflated price
This case specifically addressed whether gain from the sale of the property resulted in ordinary income or capital gain. In order to determine this distinction the Tax Court identified five factors:
(1) The nature of the acquisition of the property – Addresses the primary purpose behind the initial purchase of the property. The Court does recognize that the initial purpose can change. In such cases it is the dominant purpose during the holding period that is critical in the determination.
(2) The frequency and continuity of sales over an extended period – The more frequent and greater number of sales likely indicates sales of real property held as inventory while infrequent sales for larger quantities typically indicates real property held as an investment.
(3) The nature and the extent of the taxpayer’s business – Were the sellers activities more akin to a real estate developer’s involvement in a development project or to an investor’s increasing the value of his holdings? For example, in the case noted above the Tax Court incorporated the property owner’s construction of water and wastewater systems in making their decision.
(4) The activity of the seller with regard to the property – Reviews the role the seller has in actively selling the property (especially individual lots).
(5) The extent and substantiality of the transactions – Were the transactions (especially between related parties) at arms-length or is the purchase price taking into account profit down the line?
WHAT DOES THIS MEAN TO YOU?
If you are planning on selling a piece of land, an analysis needs to be made as to what the correct characterization of that land should be. Your tax advisor should be able to help guide you through the process. Each set of facts and circumstances is different, and outcomes can vary drastically. Therefore it is important to carefully substantiate (and document) the decision made.
There are also planning opportunities present. Knowing the rules and the impact of the outcome allows you to optimize the tax treatment of your gains or losses by not inadvertently choosing an outcome that is 1 – not correct and 2 – less favorable.
Selling a piece of land? Refer to “The 5!”
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