To be a Dealer or Investor? (Terry Pool Commentary)

The boom in the real estate market over the past several years has been record breaking in many areas of the country, not to mention Northwest Arkansas. Many people experienced the value of their properties increase at an unprecedented pace.

However, the push to turn their dirt into dollars has caused many developers to overlook, at their detriment, various real estate planning strategies that could provide substantial increases in profit from their respective developments.

A common scenario is the group of individuals that own a parcel of undeveloped property and have the desire to plat, build roads and sell lots. Though this is a relatively simplistic look at the development process, such a basic business model has provided many developers with sizeable (and sometimes not so sizeable) gains as the lots are sold.

Unfortunately, many times such gains could have been substantially increased with the implementation of certain predevelopment planning strategies. One such strategy is in the area of “investor” or “dealer” status when recognizing gain on the sale of real estate. The resulting status of the taxpayer can make the difference in paying up to 20 percent less in federal taxes.

Generally stated, an “investor” is one who owns investment property that is not held for the sale to customers in the ordinary course of business of the taxpayer. On the other hand, a “dealer” is generally one who owns real property for the sale to customers in the ordinary course of business of the taxpayer (i.e. inventory).

Under the federal tax laws, an investor is subject to capital gains tax on the profit derived from the sale of their property. Tax is 15 percent for an investor owning property for more than one year.

(For those investors owning less than one year, the rate is the same as the investor’s ordinary income tax rate, however another planning strategy utilizing the tacking method in 1031 transactions can be implemented to provide for a holding period of more than one year.)

A dealer’s gain is subject to ordinary income tax, which can be as high as 35 percent. Obviously, with a 20 percent difference in tax between the two taxpayers, the status of investor, rather than dealer, is preferred.

Determining whether a taxpayer is an investor or dealer is decided by the IRS on a case-by-case basis, however some of the determining factors are:
• the nature and purpose for which the property was acquired,
• the extent and type of improvements made to the property,
• advertising the property for sale and continuity or frequency of sales of the property as opposed to isolated transactions.

A planning strategy commonly used by developers is splitting the predevelopment appreciation in the property from the actual physical development of the property.

Many times, the predevelopment appreciation is the largest portion of the overall developed property. Under this strategy, the property is sold by the “investor” to a controlled “S” corporation, which acts as the development entity.

Such a development entity purchases the property from the investor with an installment promissory note with a fixed maturity date and a principal amount equal to the predevelopment appreciated value of the property.

An important factor in this strategy is that the investor shall not have performed any acts of development, such as building roads and improvements or marketing lots, in order to preserve the investor status.

The development entity will then proceed to obtain necessary funds (either through capital investments or loans) to physically develop the property and sell lots. Principal and interest payments on the note are paid to the investor only as lots are sold.

The gains recognized by the investor are treated as capital gains, taxed at the 15 percent rate, and any gain recognized by the development entity is taxed at the shareholders’ ordinary income rates.

Using this strategy, a substantial portion of the gain derived from the development of the property is taxed to the investors at the long term capital gain rates of 15 percent, rather than ordinary income tax rates, usually resulting in substantial tax savings.

The above strategy can be very complex and must be tailored for the facts and circumstances surrounding each particular development, however, even with the added structuring costs, such strategy can change the economics of a good development into a great one, and make a marginal development worthwhile.

Terry W. Pool is a partner with the national law firm of Kutak Rock in their Fayetteville office. Pool practices commercial real estate and related transactions. The above is provided as general information and should not be relied upon as legal advice to any particular person or entity. Any party interested in implementing any of the above strategies should consult with a tax professional.

Any federal tax advice contained in this article should not be used or referred to in the promoting, marketing or recommending of any entity, investment plan or arrangement, nor is such advice intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties under the Internal Revenue Code.

Secretarial Treasure

We’re happy President Bush chose Henry M. Paulson Jr., chairman and chief executive of Goldman Sachs Group, to succeed John Snow as Treasury secretary.

Let’s hope the Bush administration isn’t just putting lipstick on a pig, as some economic analysts have suggested.

President Bush has never been one to spread power and decision-making authority. Just ask his last two Treasury secretaries, John Snow and Paul O’Neill. But Bush has promised Paulson, who was quite reluctant to accept the post, more influence, apparently on the same level as the secretaries of Defense and State.

We sure hope that’s the case. This country faces a bevy of economic challenges, and the Treasury secretary job demands more than a cheerleader. Though the economy looks strong as a whole and the unemployment rate is falling, the country still faces a growing deficit, a widening trade imbalance, a fluttering stock market and a falling dollar.

Paulson’s expertise in capital markets should serve the economy well. So too should his experience in dealing with that other elephant in the room: China.

Paulson has met with several Chinese officials over the years, including President Hu Jintao, and made more than 70 trips to the country since 1990. Paulson is also the founding member of a business school there.