Real Estate Gains Can Be Taxed 3 Different Ways
Let’s take a break from the rants about how tough it is to build anything these days to a technical area of the tax law which is often misunderstood by most people in the real estate world. We’ll delve into the character of real estate gains in this topic so that you’re armed with the knowledge of how to consider your future dispositions.
The Three and the Who
Quite simply, gains on the sale of real estate fall into three neat little buckets: ordinary, long term capital gain, Sec 1231 gain. Based on a facts and circumstances approach, two investors holding an identical property can have completely different tax outcomes upon their disposition. Therefore, it’s important to note that the type or condition of the property holds very little importance, whereas WHO owns that property is the driving force in calculation of this gain. Dealers in real estate typically will fall into the ordinary bucket, whereas investors can avail themselves of some sort of capital gain treatment under IRC 1221 or IRC 1231.
So what are dealers and what are investors? The courts primarily look at whether the investor acquires and holds property primarily (as a first priority) for sale to customers. Investors are acquiring property primarily for investment purposes and not for sale. This may still be hard to determine, so some key factors to consider would be things like the number of times the taxpayer sells properties, the extent of improvements made to a property, the initial primary purpose of the acquisition, the holding period, and the manner in which property was acquired. I wish there was a bright line test to help determine whether or not a taxpayer falls into one category or another, but that’s basically what the tax courts are there to decide. My recommendation is that if you’re seeking to be an investor, you build facts and circumstances that support you NOT looking like a dealer. [Customized Real Estate Tax Strategies]
A Set of Stories.
The best example I can give to illustrate the above is the story of the Herbert Homebuilder and Isabella Investor. Herbert owns the company, Herbert Homes, LLC (very original name) and buys large tracts of land that used to be farmland and converts them to be subdivided into hundreds of homes which will then be sold off individually. Herbert is in the business of selling homes as a dealer, thus the sale of each home is no different than selling bags of chips at a grocery store. The sale price less the cost of good sold resorts in a profit, which is taxed at the applicable ordinary tax rates of the taxpayer (21% for corporate, 37% for individual).
Isabella Investor buys a home from Herbert and rents it out to some tenants for 5 years. At the end of year 5, Isabella decides she is ready to dispose of the property. Since the property was used in the course of a trade or business (the rental business), Isabella can characterize her gains from the sale as a 1231 gain, which is taxed at long term capital gains rates (without having to deal with pesky net investment income tax considerations). Depending on her tax situation, she’ll either pay 0%, 15% or 20% of the gain in federal income taxes. However, if she sold it for a loss, the loss would be ordinary and could be used to offset her other income such as wages and business.
Let’s try a different scenario out with the same players!
Herbert acquires a 100 acre farmland and subdivides the property into 250 homes. Herbert plans to build the homes in 5 phases, where he will build and sell 50 homes at a time. He finishes 125 homes before the market conditions change and he decides it’s not economical to build the remaining 125 lots and decides to sell the unfinished portion of the subdivision to Isabella. If he sold it for a gain, most likely it will still be ordinary, but usually these scenarios result in a loss, which would mean Herbert realizes and recognizes an ordinary taxable loss.
Isabella is an opportunist and acquires the lots from Herbert at a steep discount. She has no plans to build homes and instead will simply hold the land and pay the property taxes until the market one day shifts in favor of homebuilding once more. After 4 years, the demand for homes increases and Isabella sells her lots to Horatio Housemaker. The gain on the sale would be characterized as long term capital gains, but not as an IRC 1231 asset since it was not held for use in a trade or business. She simply speculated and held an investment and sold it later. In this case, Isabella would pay taxes at 0%, 15%, 20% and potentially be subject to a 3.8% net investment income tax surcharge, depending on her taxable income. If Isabella sold it at a loss, she would have a long term capital loss, which can only be used to offset capital gains (except for $3,000/year against ordinary income).
Next Steps
Hopefully this helps you understand the impact of your activities as a real estate mogul on your tax outcome. As you can see, when someone asks me how much tax they will pay on the disposition of their property, my answer is “it depends.” Remember, if you’ve already sold the property, then you’re too late to make changes to the outcome. This is why we always recommend a proactive, long term approach to tax planning. Reach out to us if you’d like to discuss this topic further if you’re considering disposing of a property in a taxable exchange.
