This article was initially published by Bloomberg BNA on September 7, 2018. This article was also republished by Bloomberg BNA Real Estate Journal on September 26.
Real estate crowdfunding is expanding all over the country. Platforms such as Fundrise, RealCrowd, Crowdstreet and hundreds of other platforms are attracting institutional and individual investors alike, with opportunities to focus on specific types of real estate investments.
The model is very simple; invest your money with other accredited investors in a vehicle managed by professionals, into which real estate in your particular niche is acquired, developed or improved, managed, held, rented and/or sold, hopefully at a profit. While the model is simple, what may not always be apparent is whether the investor is really an “investor” or a “dealer” under IRS rules and the distinction is significant from a tax standpoint.
Generally, when qualifying real property is held for more than one year before it is sold, it qualifies for preferential long-term capital gain tax rates on the gains recognized. Long-term capital gain tax rates in 2018 are 0 percent, 15 percent, and 20 percent, depending on the individual’s tax bracket. These rates are considerably lower than the 37 percent maximum rate for ordinary income. In addition to the one-year requirement, the real property must also meet one of the following tests in order to qualify for the long-term capital gain tax rates:
(1) Qualify as a capital asset (dealer vs. investor); or
(2) The gain must constitute “tax code Section 1231 gain.”
Capital assets include real estate not held primarily for sale to customers in the ordinary course of the seller’s trade or business. The gain on the sale of a capital asset is taxed at the capital gains tax rate. The gain on the sale of real estate held primarily for sale to customers in the ordinary course of the seller’s business is treated as ordinary income and taxed at ordinary income tax rates. The seller, in the latter case, is considered a “dealer” as opposed to an “investor” in the former case, with respect to such real property.
Capital asset - dealer or investor?
In order to ensure that gain from the sale of real property that has been held for more than one year is taxed as long-term capital gain, it is critical that the seller not be considered a dealer with respect to the particular piece of real property. Whether a seller is considered to be a dealer with respect to a piece of real property depends upon the facts and circumstances of each case—there is no precise definition of a dealer. However, there are certain factors that taxpayers should consider when structuring transactions to help them determine their status.
Generally, the three factors considered in determining investor or a dealer status are:
(1) Whether the seller was engaged in a trade or business (and, if so, what business);
(2) Whether the property at issue was held primarily for sale in that business; and
(3) Whether the contemplated sales were “ordinary” in the course of that business.
Additionally, various other factors are considered (some of which overlap). The factors are:
The acquisition of property primarily for the purpose of selling it suggests the purchaser is a dealer. Intent may be inferred from statements and documents created near the time of purchase. It is important to note that a person’s purpose for holding real property may change over time, and that change in purpose may be taken into account in determining whether the person is a dealer.
Selling Activities and Advertising:
The nature and extent of selling activities and advertising with respect to the real property. The more selling activities, the more likely the seller is a dealer.
The extent of subdividing and development with respect to the real property. Development activities include subdividing, grading, installing utilities, and building roads. Investors generally wait for property to appreciate in value, although there is some authority suggesting that physical improvements to property are more likely to suggest that a seller is a dealer than legal improvements (e.g., subdividing).
The use of a business office to sell the real property, which suggests dealer status.
Supervision over selling agent:
The character and degree of supervision over the agent selling the real property. A greater level of supervision over the agent may result in dealer status.
Time between purchase and sale:
The length of time between the seller’s purchase and sale of the real property. A long holding period suggests that the seller is not a dealer, but there is no bright line rule.
Substantiality of sales:
The number, extent, continuity, and substantiality of sales. Selling a large number of properties over the course of several years suggests that one is a dealer. Substantiality refers to the dollar value of sales. Real estate sales will be substantial if the income generated by them is large relative to the seller’s other sources of income. Unfortunately, there is no bright line test that provides that a certain number of sales within a certain period of time for a certain value will (or will not) cause the seller to be a considered to be a dealer.
When a person owns more than one piece of real property, each piece of real property will be examined separately with respect to the person’s dealer status. However, once the person is considered to be a dealer with respect to one or more pieces of real property, it becomes more difficult for that person to establish that he is not a dealer with respect to any particular piece of real property.
UNCERTAINTY ABOUT INVESTMENT PROPERTIES
It is very difficult to predict what courts and the IRS will decide based on the various factors. For example, a seller may be considered to be a dealer if he acquires a single piece of property with the intention of immediately selling it and in fact immediately attempts to sell it. (See e.g., Morley v. Commissioner). On the other hand, a seller who sells 22 pieces of real property within a three-year period may be considered to be an investor when he makes almost no efforts to sell the 22 pieces of property and all of the offers to purchase the real property are unsolicited. (See e.g., Byram v. U.S.).
In one case, an S-corporation that was formed to hold a single tract of real property subdivided part of that tract into 79 residential lots, all of which were sold in a single transaction. Another portion of the tract was condemned by the state, and a third portion of the tract was eventually subdivided into 30 residential lots and sold. The U.S. Tax Court, focusing only on the creation and sale of the 79 lots and relying on the taxpayer’s intention to sell the tract in a single transaction, concluded that the tract had not been held for sale to customers in the ordinary course of a trade or business. (See e.g., Buono v. Commissioner). However, the Tax Court determined in another case that a taxpayer held two pieces of land for sale to customers in the ordinary course of his business where he attempted to subdivide each tract.
Considering the uncertainties in the determination of the dealer status, investment properties should be selected with a view towards minimizing the number of sales and subdividing each seller will have to make in order to reduce the risk of being considered to be a dealer. This means that sellers should ideally attempt to limit their holdings to three or fewer tracts of land. The Tax Court has indicated on at least one occasion that the sale by a corporation of three pieces of land will not necessarily trigger ordinary income treatment of the sales. If the seller keeps his activities to an absolute minimum (e.g., he sells property only in response to unsolicited offers and does not subdivide any tracts), he might be able to comfortably hold additional properties. Sellers should also avoid subdividing more than a single tract of land.
THE SECTION 1237 SAFE HARBOR
Because it is often difficult to determine whether a person is a dealer, Congress created a “safe harbor” rule that provides that subdividing a tract of land for the purpose of selling it and engaging in certain activities in connection with its subdivision or sale will not alone cause a seller to be treated as a dealer. This safe harbor benefits people who own large tracts of land (a family farm, for example) that might be difficult to sell as a single piece of land. The scope of this safe harbor is quite limited.
There are six requirements that must be satisfied to take advantage of the safe harbor. The requirements are as follows:
- Persons other than “C” corporations
- Individuals, partnerships consisting of individuals
- Includes LLCs taxed as partnerships
- Must consist of land
- Conversion of a rental apartment to condominiums is NOT eligible
- Does not apply to subdivision and sale of improvements
- Real Property consists of a lot of parcels which are part of a single tract of real property
May NOT hold any other real property primarily for sale to customers in the ordinary course of a trade or business
May NOT have held any part of the property being sold primarily for sale to customers in the ordinary course of a trade or business
May NOT demonstrate or perform any of the following:
- Intention in prior years (or at the time of acquiring the property subdivided) to hold the tract primarily for sale in its business
- Subdividing other tracts in the same year
- Holding other real property for sale to customers in the same year
- Constructing a permanent real estate office to use in selling other real property
May engage in ONLY ONE of the following in some cases:
- Holding a real estate dealer’s license
- Selling other real property which was clearly investment property
- Acting as a salesman for a real estate dealer, but without any financial interest in the business
- Mere ownership of other vacant real property without engaging in any selling activity whatsoever with respect to it
Advertising, promotion, other selling activities or the use of sales agents in connection with the lots in the subdivision (BUT NOT MORE).
Must have held the property for at least five years prior to sale (this includes the period during which certain other persons owned the property if the property was transferred pursuant to certain tax-free transactions).
No “substantial improvement” that increases the value of a lot (rather than the entire tract) by more than 10 percent.
Substantial improvement includes:
- Construction of commercial or residential buildings, or a shopping center
- Installation of hard surface roads or utilities such as sewers, gas, or electric lines
Permitted improvement includes:
- Constructing a temporary structure used as a field office, surveying, filling, draining, leveling and clearing operations, and constructing minimum all-weather access roads, including gravel roads where required by the climate
- Building or installing water, sewer, or drainage facilities (either surface, sub-surface, or both) or roads, including hard surface roads, curbs, and gutters if:
- Seller held the property for 10 years; and
- Seller elected not to adjust the basis of the lot sold or any other property held by it for any part of the cost of such improvement attributable to such lot and not to deduct any part of such cost as an expense
Persons subject to the substantial improvement rule:
- Certain members of the seller’s family
- A corporation controlled by the seller
- A partnership of which the seller is a member at the time of improvements are made
- A lessee if the improvements represent rent
- Certain governmental entities
- Anyone acting on behalf of the seller and sharing with the seller any ownership interest in the improvement
- Up to five lots in the same tract of real property sold may be subject to capital gain tax rates
- If sixth lot is sold in the following year, then 5 percent of the sale of the sixth lot is taxed at the ordinary income tax rates
- If sixth lot is sold in the same year as the first five lots sold, then 5 percent of the gain from the sale of all six lots sold is subject to the ordinary income tax rates
- Must wait five years after the sale of the fifth lot of a single tract to reset the limit
Section 1231 gain (property used in a trade or business)
Section 1231 gain is taxed at the preferential long-term capital gain rates. Section 1231 gains generally includes any recognized gain on the sale or exchange of real property that has been held for more than one year and that is used in a trade or business. Regulations under Section 1237 specifically state that Section 1237 may be applied in determining whether gain is Section 1231 gain. It is, however, rare for real property to both be subject to the Section 1237 safe harbor and be used in a trade or business.
Selection of properties
Outside investors seeking to treat gain from the sale of real property as Section 1231 gain, and who are not averse to recognizing ordinary rental income for a period of time, may be interested in rental properties, such as office buildings and apartment buildings, where the seller expects to be actively involved in the business of renting the property.
Properties that are not desirable candidates for investment where the investor wishes to treat gain as Section 1231 gain include rental properties that are subject to a long-term triple-net lease or that otherwise require little marketing or management activity by the owner.
Below are examples of different types of real property that are suitable (or unsuitable) for use in a trade or business:
Prior to investing in any real estate crowdfunding investment, it is critical to understand the type of properties that the manager will select (e.g., vacant land, commercial properties, residential, etc.), what the manager intends to do with the properties (e.g., subdivide, rent, flip and sell, etc.) and how and when such activities are expected to occur. The tax consequences of these factors can make a dramatic impact on the taxation of investment gains and could affect the investor’s bottom line.
Clyde Tinnen is a partner in the Withers corporate team. His practice focuses on debt and equity financing transactions and mergers and acquisitions. The author thanks Jennifer Park for her assistance with this article.