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Obtaining Long-term Capital Gains Treatment for Development Property

Capital Gains Development PropertyTo maximize the after-tax gain on a real estate development transaction, the investor/developer is greatly incentivized to obtain long-term capital gains treatment where the highest federal capital gains rate of tax is 20% compared with the top ordinary income rate of up to 40%.

The Internal Revenue Code (IRC) provides that long-term capital gain treatment applies to a gain from the sale or exchange of a capital asset held for more than a year. Section 1221(a)(1) does not allow capital gain treatment on gain associated with “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business” because these assets are not capital assets, but constitute inventory.

Factors the IRS considers in determining whether the taxpayer held property as investment (capital asset) or held it for sale to customers in the ordinary course of business (inventory or dealer property) include, but are not limited to, the following:

  1. What was the intent of the taxpayer when the property was purchased?
  2. If and when did the intent change?
  3. Did the taxpayer acquire the property and shortly thereafter place the property up for sale?
  4. Did circumstances change for the taxpayer, thus causing a change in intent?
  5. What business is the entity involved in that owns the property?

Because the Supreme Court has narrowly defined the definition of a capital asset, a taxpayer wanting to obtain capital gain treatment on the sale of development property has the burden of establishing that the property was held for investment. Additionally, the holding period of the capital asset by the taxpayer must be long term, which the IRC requires to be longer than a year.

Planning for capital gain treatment prior to purchasing a potential development property is crucial to receiving the long-term capital gains treatment, thereby, minimizing income taxes and maximizing the after-tax return on the property. Disallowance of the favorable treatment can be an unexpected disappointment when planning was not done.

At Layman & Nichols, P.C., we offer tax and real estate planning experience and expertise to structure the purchase of potential development land, properly structure the transfer of land from the acquisition entity to the development entity, and properly structure the entity that will develop the project.

If you have additional questions or want to learn more, feel free to contact us.

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