Development: Qualifying for Capital Gain
by Eric Kea and David Patch
The gain recognized by real estate developers upon sale of developed land is generally ordinary income because land held "primarily for sale to customers in the ordinary course of a trade or business" does not qualify as a capital asset. However, if land is held in an entity such as a partnership or S corporation, it is the business and intent of the entity itself and not the partners or shareholders that is determinative. Thus an entity owned by a real estate developer can obtain capital gain on the sale of land if it is not itself engaged in a real estate development business.
Achieving Capital Gain
To take advantage of the planning opportunity, real estate developers should acquire land they may want to develop in an investment entity. Activities that enhance the property's value, such as rezoning efforts, engineering studies and preliminary platting can be pursued by the entity without tainting the character of the land so long as the activities do not rise to the level of a trade or business. If and when the land is ready for development, it can he sold to a development entity with gain from the sale qualifying as capital gain.
Caution: An important point to remember is that the investment entity and the development entity cannot be the same type. If one is a partnership, the other must be an S corporation or other form of ownership.
Varying degrees of related ownership between the investment and development entities are permissible, depending on the circumstances, but courts have respected up to 100 percent common ownership in some cases. The end result is that developers who would have recognized ordinary income on the development and sale of land obtain capital gain treatment on pre-development appreciation.
Timing is Important
This strategy is best implemented before acquisition, but in any case must be prior to significant development activity with respect to the subject property. Advance planning is often necessary, and the participation of a tax professional with knowledge of the relevant issues is highly recommended.
Eric Kea is a Partner and the Chairman of the National Passthrough Entity Tax Consulting Group at BDO Seidman, LLP. He can be reached at (212) 885-8101. David Patch is Senior Manager in BDO Seidman's National Tax Office and is a member of the National Passthrough Entity Tax Group. He can be reached at (301) 634-4965.
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