THE “SHOVEL IN THE GROUND PROBLEM”: …

1 THE SHOVEL IN THE GROUND problem : PLANNING FOR real estate development activities Nicholas J. Bakatsias Carruthers & Roth, Box 540 Greensboro, NC 27402 (336) 379-8651 INTRODUCTION The uncertainty surrounding the real estate dealer versus investor issue has generated a substantial degree of caselaw over the years. Much of this uncertainty stems from what has been coined as the shovel in the GROUND problem , when do the taxpayer s value-enhancing activities , such as landscaping or installing sewer systems, convert investment property into dealer property, such that ordinary income tax consequences will result. This paper will explore some of the issues associated with the dealer versus investor challenge and will suggest possible tax planning strategies to achieve a favorable tax result for your client.

2 However, as most tax practitioners who have tackled this issue can attest to, there is no definitive answer to this issue. Significance of Characterization Gain and loss recognized from the disposition of real property must be characterized as either ordinary or capital in order to determine the appropriate tax treatment of the gain or loss. For non-corporate taxpayers, the capital gains tax rate cannot exceed 5%, 15% or 25%, depending on the type of capital gain (Sec. 1(h)), whereas the nominal marginal tax rate applicable to ordinary gains can be as high 35% (Sec. 1(i)). With respect to corporations, the tax rates applicable to capital gains portion of taxable income cannot exceed 35% (Sec. 1201), which is the highest marginal rate applicable to corporate taxable income. In addition, non-corporate taxpayers can deduct capital losses only to the extent of capital gains increased by the lesser of (i) $3,000 or (ii) the excess of capital losses over capital gains (Sec.)

3 1211(b)). Corporate taxpayers can only deduct capital losses to the extent of capital gains. Capital Gain Defined To obtain capital gain treatment, there must be (i) a sale or exchange (or deemed sale or exchange), (ii) a one-year holding period if long-term treatment is desired, and (iii) a capital asset (Sec. 1221) or an asset held for productive use in a trade or business (Sec. 1231). Under 1221 of the Code, a capital asset is defined as any property held by a taxpayer, whether or not connected with a trade or business, subject to eight exceptions, three of which are germane in the context of real estate business activity. The three significant exceptions are: (1) Stock in trade or other property of a kind which would be included in inventory if on hand at the close of the taxable year and property held primarily for sale to customers in the ordinary course of business (Sec.

4 1221(a)(1)); (2) Depreciable property and real property used in a trade or business (Sec. 1221(a)(2)); and (3) Accounts and notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of stock in trade, inventory, and property held primarily for sale to customers (Sec. 1221(a)(4)). Sale or Exchange In order to obtain long-term capital gain, the taxpayer must demonstrate that a sale or exchange of a capital asset held for more than one year occurred and the gain was taken into account in computing gross income (Sec. 1222(3)). Under the broad definition of Treasury Regulation (d), a sale is transfer for property for an amount of money or a money equivalent that is fixed and determinable. Similarly, an exchange is a transfer of property for property other than money or a money equivalent.

5 Generally, capital gains and losses result from the sale or exchange of a capital asset, though certain transactions not involving the sale or exchange of a capital asset are deemed to constitute the sale or exchange of a capital asset ( , 1231(a)(1), 1233, 1234, 1234A, 1235). In other situations, property may be characterized as a capital asset even though it might not otherwise be so characterized under certain other circumstances ( , 731, 741, 1237, 1256). Other transactions that would normally be characterized as sales or exchanges of capital assets are treated as ordinary income transactions ( , 707(b)(2), 751, 1231, 1236, 1239, 1242, 1243, 1244, 1245, 1248, 1249, 1250, 1252, 1253, 1254, 1255, 1257, 1258, 1287). Finally, in other situations, the Code deems a sale or exchange to exist even though such characterization might not be deemed to exist in other situations ( , 1241, 1271).

6 Other sections in the Code deal exclusively with the recognition of gain or loss and on the ascertainment of whether a specific transaction constitutes a sale or exchange. These provisions include, but are not limited to: Sec. 1001 - determination of amount of and recognition of gain or loss. Sec. 331 - distributions in liquidation of a corporation. Sec. 1031 - exchange of property held for productive use or investment. 2 Sec. 1033 - involuntary conversions. A few of the special characterization rules referenced above that affect the disposition of real property or assets used in a real estate business will be discussed in this paper. Under Section 1231(b), net gain in excess of losses from the sale of Sec. 1231(b) property is characterized as a capital gain, while net losses on the sale of 1231(b) property results in an ordinary loss.

7 Thus, in dealing with Section 1231 property, the taxpayer has the benefit of capital gain rates and the avoidance of the capital loss limitations. However, the Code mandates that the taxpayer recapture, as ordinary income, the lesser of (i) the aggregate amount of the unrecaptured ordinary losses deducted under Section 1231 in the preceding five years, or (ii) the Sec. 1231 gain for the current year. When analyzed with the recapture provisions of Section 1245 and Section 1250, this recapture provision may make it more difficult for the taxpayer to obtain capital gain treatment on the sale of business assets. Holding Period In order for a taxpayer to achieve the more favorable long-term capital gain rate (15%), the property sold or exchanged must have a holding period longer than 12 months. The holding period commences on the day after the acquisition date and is computed through the day of disposition of the property.

8 Under Section 1223(1), the holding period may be tacked on in a situation where the basis of property acquired is determined in whole or in part by reference to the basis of property transferred, such as in nontaxable exchanges, involuntary conversions, foreclosures and certain other situations. Interestingly, Section 1223 does not reference a holding period for assets held for resale in the ordinary course of business ( , inventory). Since an asset held as inventory does not appear to generate a holding period under the Code, the holding period would only seem to run during the period of time the asset is held as a capital asset or asset held for productive use in a trade or business. Capital Gain Treatment With respect to the tax treatment of depreciable real property, the maximum tax rate is modified for the deemed depreciation recapture.

9 Accordingly, any depreciable real property sold after May 7, 1997 must be treated, for maximum tax rate purposes only, as if it were Section 1245 property. To the extent that depreciation on the property would be recaptured as ordinary income under Sec. 1245, the deemed depreciation recapture would be taxed at a rate not to exceed 25%. The capital gain above the deemed depreciation recapture is subject to the normal capital gains rate. 3 Example 1. Bob purchased a shopping center that is Section 1245 (because it was placed in service in 1985 and thus subject to Accelerated Cost Recovery System depreciation) for $9,500,000, and depreciated it under an accelerated method, claiming $5,000,000 in depreciation deductions. Bob sells the apartments to Sue for $12,000,000, creating a gain on the sale of $7,500,000 ($12,000,000 sales price less adjusted basis of $4,000,000 ($9,500,000 - $5,000,000)).

10 Since the property is characterized as Section 1245 property, the $5,000,000 in depreciation will be taxed ordinary income. Therefore, the gain equal to the deemed depreciation recapture of $5,000,000 would be subject to a maximum 25% tax rate. The remainder of the gain - $2,500,000 - would be subject to the capital gains maximum rate. While the deemed depreciation recapture is referred to as unrecaptured section 1250 gain, this amount is not actually Section 1250 recapture for any purpose other than the maximum tax rate calculation. Accordingly, the unrecaptured section 1250 gain is not subject to the rules that relate to depreciation recapture, required recognition in the year of an installment sale of the property, etc. (discussed below). Identifying the real estate Investor While the capital gain benefits once available to the real estate investor have been diminished by recent amendments to the tax laws, such investors can still benefit from Section 1031 nontaxable exchanges, Section 1033(g) (relating to condemnation of real property held for productive use in a trade or business or for investment) and Section 453 installment sale reporting, benefits that are not available to dealers of real property.