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Real Estate Developer-to-Investor Status Switch Didn’t Fly with IRS

By TaxWealth -

Developing an action plan to maximize the profit you keep in your pocket in anticipation of a coming tax bill makes good business sense. One court decision by the United States Court of Appeals raised this issue: It dealt with the tax implications of a real estate development versus land considered to be investment property. The seller did not think through all possible outcomes and anticipate future tax obligations.

This case involved a real estate owner who spent years trying to develop a property in Florida. He and a partner bought woodland from International Paper back in 2002, and started working through the process to gain approval to build residential homes on the property. This took years (as it often does!) and during that time, certain key events occurred:

  • His original partner sold out in 2006, and the remaining partner set up a new corporate entity with his wife as a partner.
  • County government kept moving the goalposts, with evolving road and easement mandates, which made it difficult for him to make money. Consequently, to cover some of his expenses, he sold lots in advance of development.

Finally, the property owner and his wife decided to sell their position to another developer, which for them was a sound business decision. The property had appreciated since 2002 and they netted for themselves a gain of $8,578,636 on the sale.

Claiming on his tax returns that the profit on the sale was a capital gain rather than regular business income, he switched his classification from “land investor” to “real estate professional.” Doing this would save he and his wife $1,784,242 in taxes.

Unfortunately, this did not pass muster with the IRS and the new classification was denied. Though the property was never properly developed outside of one dirt road, and its value appreciation had been driven by outside events as the county developed around it, the IRS looked back through the history of the tax returns that featured the expenses of this project. They discovered that this taxpayer had always presented himself as an active developer and deducted the expenses incurred by the project each year, rather than capitalizing them against appreciated property value.

As far as the IRS was concerned, his claim to being a “real estate professional” and no longer a developer was illegitimate, and it was viewed as an attempt to avoid his gain-on-sale being taxed as regular income.

How could he have avoided this result? One possibility was for him to have anticipated the need to give up on the project and sell the property. With that option in mind, he might have absorbed some short term pain (capitalizing his expenses rather than taking deductions each year) to capture the more advantageous long-term capital gain tax rate.

As one CPA points out, the time to do that was when his first partner sold out. That change was a material shift in the project ownership, and would have been a rational time to re-characterize his role as an investor instead of a developer. The CPA offers further insight, saying, “I think that more careful planning and the introduction of one or more special purpose entities might have enabled this taxpayer to achieve capital gains treatment on a significant part of the transaction.”

All of this is hindsight, of course, and this taxpayer and his wife may have had no thoughts about selling the property in 2006.  However, the take-away lesson to be learned by all of us is to anticipate and plan ahead for future tax events.  Understand the circumstances at hand and collaborate with an experienced proactive tax planning advisor to identify all your options and their financial impact so that you can make sound informed decisions. The result can be a much more profitable outcome for you to enjoy.

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