Preface: Real estate partnerships require specific and appropriate tax planning to effectively manage tax attributes, i.e. ordinary tax or capital gains? 

Ordinary Tax or Capital Gains on Your Real Estate Investment Partnership

Real Estate investment enterprises can plan effectively to lower taxes on transfers of real estate holdings, and their increase earnings for investors. Typically the key for determining tax attributes on real estate is the intent for property.

 

Let’s say a real estate investment partnership with 10 investors purchases a 50 acre tract for $5,000,000. If the value appreciates to $6,000,000 in two years the tax difference between capital gains and ordinary tax rates will likely be a significant difference in the earnings of the partnership. The difference between say a 20% capital gains tax and 39% ordinary tax rate on a $1,000,000 gain is significant. Securing the safeguards for capital gains is where the right tax advice can pay-off big for you.

 

If the investment partnership is for sale of land to customers, and that sale is the ordinary course of business – real estate development principally – then the IRS will likely say the sales of land lots are ordinary gains. This costs a lot more tax.  The difference between capital assets and assets sold in the ordinary course of business is not a conspicuous definition. These factors should be well documented before IRS audit, to provide substantiation of tax treatment of your business assets, e.g. why the sale of the property is a capital gain.

 

The tax substantiation should include among numerous items, the purposes that support the capital gains treatment with the nature and purpose for acquiring the asset, i.e. the asset being real estate or land, and anticipated duration of ownership. The extent of improvements on the property, and the transactions involved. What is ordinary business in say the partnership, e.g. real estate trading or development and types of advertising on the transactions and brokers involved? What the purpose was for the property held at the time of sale, e.g. investment?

 

If your partnership tax return is filed with a description of “real estate development” for purpose of entity, then you will likely have a lot of explaining to do in a IRS audit if your apply capital gains treatment to sales of property lots. Factors that can help support the investment aspect of real estate partnerships include not using the land for office or rental space, or incurring significant development expenses, e.g. $125,000,000 investment in rain water management.

 

Here are specific idea’s for securing capital gains treatment of real estate gains.

 

1. Create categories of gains on the sale of property. This requires two partnerships. One partnership with investment purposes, and the second the purpose of the sale to customers. Note: You need to be careful to avoid say IRC Section 707(b)(2) ordinary gain treatment that is applicable to transfers of property between businesses or individuals with 50% or higher tax attribution, another word for related party ownership. So if you own 75% of the partnership for investments, and 60% of the development partnership, you could still be subject to ordinary gains on the sale from the investment partnership to the development partnership within the parameters of Section 707. In addition separate books and records must be kept for both companies.

2. Minimize the number times the land changes ownership and neither partners or employees not be actively involved in marketing or selling the real estate, e.g. some one payroll showing the land to potential customers will likely make it a development company subject to ordinary tax rates.

3. During the time the property is held in the investment company, all activities must avoided that would indicate development of the property.

4. Be careful, all sales must be at appraised fair market values.

 This article is not to be construed as tax advice. It is bring awareness to the tax risks a real estate partnership may be subject to that adjust earnings. Talk with your tax advisor before making any significant financial decisions involving future tax attributes.

A well planned tax attribute, will payback multiples for the time invested in appropriate initial planning as briefly depicted in this article.