When an Owner of Real Estate Contemplates a Sale
As the real estate market continues to gather steam, many owners of rental properties are again contemplating the sale or exchange of their holdings. Questions facing a number of these owners are whether the gain or loss on the sale qualifies for capital gain treatment (rather than being taxed at ordinary income rates); or whether the property is eligible to be exchanged tax-free in a like-kind exchange. The purpose for which the property is held at the time of its sale determines the tax consequences, not the purpose for which it was originally acquired. Temporary use of the property for a different purpose, however, does not change the primary purpose.
Change in Original Purpose
Circumstances change and as a result, the purpose for holding the property also may change. An office building may have been converted to condominiums; a personal residence may have become a rental unit or vice versa; a developer may have purchased a tract of land with the intent of subdividing and building single-family homes but because of market conditions was forced to sell the remaining undeveloped land, a contractor may have acquired property to flip and sell but in order to hold onto the property it was converted to rental units.
Ordinary Income vs. Capital Gain
For the sale of real estate to qualify for capital gain treatment, or for it to be eligible for a like-kind, tax-free exchange, the primary purpose of holding it should be appreciation in value. At the time of its sale, the real estate had to have been either held as income-producing or investment purposes (such as rental property) or held for use in the owner’s business (such as a factory, office, etc.).
When exactly does the purpose of holding the real estate change either from resale to investment or investment to resale? This is a question that the IRS and the tax courts have been wrestling with for years. In Klarkowski, a 1965 case, the court considered nine non-weighted, relevant factors which other courts still use as precedence:
- The purpose for which the property was initially acquired;
- the purpose for which the property was subsequently held;
- the extent to which improvements, if any, were made to the property by the taxpayer;
- the frequency, number, and continuity of sales;
- the extent and nature of the transactions involved;
- the ordinary business of the taxpayer;
- the extent of advertising, promotion, or other active efforts used in soliciting buyers for the sale of the property;
- the listing of property with brokers; and
- the purpose for which the property was held at the time of sale
As you can see, there is a lot of room for interpretation.
The tax courts have ruled that temporary use for different purposes does not change the character of the property. Real estate acquired and held for resale continued to be held for resale at the time of its sale, notwithstanding the fact that it temporarily became rental property during a downturn in the real estate market. Similarly, holding a property for many years has indicated an investment purpose.
Examples of When the Primary Purpose of Holding the Property Changed
- Land originally acquired to construct rental apartments (investment purpose) became ordinary income property when it was developed as condominiums.
- A taxpayer acquired land for use as a nursery (investment purpose). The business was not profitable and he fell behind on his mortgage. He found that he could make more by subdividing and improving the land, and then advertising the land for sale. The court found he had gone into the business of selling lots (ordinary income).
- Land purchased and farmed by a taxpayer (investment purpose) suffered because of a water shortage and parasite infection of the soil. Over the next eight years, the land was subdivided into residential lots, roads were built, and sewers and water mains installed. The sale of the lots was controlled by the taxpayer. The court ruled the lots were held for sale (ordinary income), and not for liquidation of an investment asset.
- A taxpayer who had acquired land to develop a mobile home park (investment purpose) began selling lots in the park when FHA and other financing for the mobile homes began drying up. The sales were deemed to be taxable in the course of business as ordinary income.
Examples When the Primary Purpose of Holding the Property Did Not Change
- A taxpayer purchased land for development. Over the next eight years, he paid for engineering plans and took out a second mortgage. He was unsuccessful in his attempt to find a developer partner and performed no additional work on the property. Four years later, the property was sold to a developer for a down payment plus future payments based on a percentage of profits from the sale of developed units. He reported the final payment as a capital gain. The court found that the land was held for resale and taxable as ordinary income. The purpose of owning the land (resale) had not changed.
- A taxpayer who was not in the real estate business (he was a politician/engineer) purchased three lots he thought were “ripe” for development. He prepared his own development plans as an engineer and had the properties rezoned. The properties were sold to a developer. The court held that he was not in the business of selling real estate, and therefore, the property was held for investment and qualified for capital gains.
- A taxpayer held property for investment. Shortly after acquiring the property, the taxpayer listed the property, prepared sales brochures and began advertising. The court found that these actions were consistent with his purpose of seeking to sell a costly investment.
As you can see, when circumstances change it is extremely important that you seek professional advice from a real estate tax expert. The difference between qualifying for capital gain tax treatment and being taxed at ordinary rates on the sale of real estate can be substantial and the fine line that separates eligibility for one over the other is tenuous.
One of our Real Estate Group specialists can help you sort through the various issues to ensure that your practice abides by federal and state employment laws. To discuss your options, or if you have questions, contact Bob Rifkin at 312.670.7444. Visit orba.com to learn more about our Real Estate Group.
How a Trust Qualified for an Exception to PAL Rules
Kadir Sunardio, CPA, CFP®
In a favorable decision for trusts that hold real estate assets, the U.S. Tax Court has held that such a trust qualified for the real estate professional exception and was therefore exempt from the limitations on passive activity losses (PALs). The court’s holding also means the trust can avoid the new 3.8% net investment income tax (NIIT) that applies to passive activity income.
Real Estate Professional Rules
“Passive activity” is defined as any trade or business in which the taxpayer does not materially participate. “Material participation” is defined as involvement in the operations of the activity that is regular, continuous and substantial. Rental real estate activities are generally considered passive regardless of whether you materially participate.
Internal Revenue Code Section 469 grants an exception from restrictions on PALs for taxpayers who are real estate professionals. If you qualify as a real estate professional and you materially participate, your rental activities are treated as a trade or business and you can offset any nonpassive income with your rental losses. You may also be able to avoid the NIIT as long as you are engaged in a trade or business with respect to the rental real estate activities (that is, the rental activity is not incidental to a nonrental trade or business).
To qualify as a real estate professional, you must satisfy two requirements: 1) More than 50% of the “personal services” you perform in trades or businesses are performed in real property trades or businesses in which you materially participate, and 2) you perform more than 750 hours of services in real property trades or businesses in which you materially participate.
The IRS Challenge
In Frank Aragona Trust v. Commissioner of Internal Revenue, the trustee had formed a trust in 1979, with his five children as beneficiaries. He died in 1981 and was succeeded as trustee by six trustees — the five kids and an independent trustee. Three of the kids worked full-time for a limited liability company (LLC), wholly owned by the trust, that managed most of the trust’s rental properties and employed about 20 other individuals.
During 2005 and 2006, the trust reported nonpassive losses from its rental properties, which it carried back as net operating losses to 2003 and 2004. The IRS determined that the trust’s real estate activities were passive activities, and the challenge landed in the Tax Court.
A Trust as a Real Estate Professional
The IRS contended that a trust could not qualify for the real estate professional exception because a trust cannot perform “personal services,” which regulations define as “any work performed by an individual in connection with a trade or business.” The Tax Court rejected this argument. It found that, if a trust’s trustees are individuals who work on a trade or business as part of their trustee duties, their work can be considered personal services that can satisfy the exception’s requirements.
Evaluating Material Participation
The IRS alternatively argued that, even if some trusts can qualify for the exception, the Aragona trust did not, because it did not materially participate in real property trades or businesses. The agency asserted that only the activities of the trustees can be considered, not those of the trust’s employees. And the IRS claimed the activities of the three trustees who worked for the LLC should be deemed activities of employees and not trustees.
The Tax Court did not decide whether the nontrustee employees’ activities should be disregarded in determining if the trust materially participated in its real estate operations. But it held that the activities of the trustee employees should be considered. It also noted that trustees are not relieved of their duties of loyalty to beneficiaries just because they conduct activities through a corporation that is wholly owned by the trust.
For technical reasons, the trust, in this case, was not required to prove that it satisfied the two-prong real estate professional test. Other trusts wishing to take advantage of the exception should be prepared to do so.