Real Estate Capital Gains: Dealer or Investor

Sales of real estate can generate favorably taxed capital gains if
you’re an investor, or higher taxed ordinary income if you are a dealer. The
following checklist will help you characterize your activities as those of an
investor and avoid dealer taint.

Capital
gain is realized on the “sale or exchange” of real estate which is not held
primarily for sale to customers in the ordinary course of your trade or
business. Code Section 1221(a)(1). Investors do not
sell to customers at a mark-up, they realize their profits from the long term
appreciation of the property held. Dealers earn
a profit by selling in excess of their cost as a result of their efforts and
labors as middlemen.  Investors, in
contrast, don’t perform merchandising functions. The determination is fact
sensitive. Your actions, and how you document them, are vital to your success.
Corroborate and strengthen the factors consistent with capital asset
characterization, and to avoid, minimize or downplay the factors indicative of
assets held primarily for sale in the ordinary course of business.

Try
to avoid continuous sales of properties to purchasers. Make sales sporadic and
over longer time periods if you can. Black v. Comr., 45 B.T.A. 204 (1941), acq., 1941-1 C.B. 2. Continuous
and substantial activities sufficed to characterize the taxpayer as a dealer
even without the other indicia of a trade or business. Suburban Realty Co. v.
U.S., 615 F.2d 171 (5th Cir), cert. denied 449 U.S. 920 (1980).

Keep
a diary. Document the actual time you spend on development and marketing
activities versus other activities.
While devoting extensive time to the real estate endeavor alone won’t
taint a property as being held for sale to customers, it’s a significant factor.
Marrin v. Comr., 147 F.3d
147 (2d Cir. 1998).

Limit
or avoid subdivision and “other improvement activity” to minimize the
likelihood of the property being deemed to be held for sale to customers. Gruver
v. Comr., 142 F. 2d 363 (4th
Cir. 1944) Limit your development activities, subdivision work and lot sales to
comply with the tax law exceptions from dealer status. Code Section 1237.

Minimize
sales activity. The greater the sales activity the greater the likelihood of
your being a dealer and the property not to be a capital asset. Comr. V.
Covington, 120 F.2d 768 (5th
Cir. 1941). Hiring an independent broker to handle all sales activities may
help if those activities are not imputed to you.

Have
a single purpose LLC purchase investment
property and minimize the involvement with your other entities. A professional
real estate developer and owner who regularly buys and subdivides tracts of
land, sells using sophisticated marketing techniques, holds lots primarily for
sale to customers, will recognize ordinary income, not capital gains. Pierce
v. Comr., 74 T.C.M. (CCH) 572
(1997).

Consider an intervening
sale to characterize some gain as capital. An increase in value due to
appreciation while merely holding property might be classified as capital gain
if you sell the property to a related entity before any development activities
occur.  Be certain to have an
appraisal of the value at that date. Then have the new entity conduct sales
activities. If successful, only the profits attributable to development
activities conducted by the related entity should be characterized as ordinary
income.

Document your activities.
Substantial efforts to obtain subdivision approval and to increase the value of
the land increases the likelihood of ordinary income. Jarret v. Comr., 66
T.C.M. (CCH) 1224 (1993). “Substantial” is a qualitative term. So maintain a diary,
correspondence, and other records to demonstrate how little effort you expended
may defeat the substantiality issue.

Keep LLC minutes
corroborating that the purpose of the acquisition is to invest and hold the
property. Maintain contemporaneous records (e.g., business plans, memorandum,
letters to counsel, etc.) that demonstrate the primary purpose was not holding
the property primarily for sale.

Be sure your operating or partnership
agreement supports investor status. Sanford Homes, Inc. v. Comr., T.C. Memo 1986-404.