Tax & Business Insights

Capital Gains Planning 

Volume 19 Issue 1 --  January/February 2007

For many years the tax law has afforded special tax treatment for the sale of certain assets held for more than a specified period of time, such as one year.  The theory is that it would be unfair to tax in one year when the asset is sold, all of the gain that accumulated over a period of years at regular income tax rates.

Congress’s desire to mitigate the effect of taxation of gain accumulated over more than one year led to a special tax structure called “Capital Gains,” under which capital gains are taxed at lower rates than ordinary income. Currently for all but those in the lowest ordinary income tax brackets the rate is 15%, in contrast to ordinary income tax rates that are often in the range of 28% to 35%.  As with all tax rules, there are exceptions, such as the 28% rate for collectibles and the 25% rate for the portion of gain attributable to depreciation claimed on some real estate.

An asset held for sale in the ordinary course of a business is considered inventory and does not qualify for lower capital gains rates when sold.  Land held for sale by a real estate dealer, for example, is “inventory” of the dealer and, when sold by the dealer, does not qualify for the lower capital gains rates. 

Does this “inventory” concept preclude a real estate dealer, such as Richard Recordless, “Dick,” from obtaining capital gains rates on the sale of the ITZMINE property he has held for 20 years? 

The answer for Dick depends on the circumstances and on his records (or the lack of them) which in turn help answer the question of whether the land held for 20 years is part of Dick’s inventory of real estate. Did Dick treat the land as part of his parcels of real estate for sale?   If ITZMINE was not part of Dick’s inventory of real estate held for sale in the normal course of his real estate business how does he establish this point?

Rather than be record-less, Dick needs to do most of the following things regarding ITZMINE: (1) establish a separate bank account to pay all taxes and expenses on the property; (2) rent or use the property in a manner consistent with investment usage such as rent the property to others for sports events, grazing cattle, raise Xmas trees, etc.; (3) report the income, if any, from the property on a separate Schedule E as part of his 1040 tax return or, even better, form an entity, such as an LLC, to hold or manage the property.

The theme here is to treat ITZMINE in a manner different from other properties held for sale in the ordinary course of Dick’s real estate business.

What if Dick Recordless had inherited ITZMINE, a 300-acre farm near D.C. and decides to subdivide it into lots and sell such lots.  Had Dick not subdivided the farm but sold it as a whole to one purchaser, the gain could be capital gain. But, what’s wrong with subdividing?

If Dick subdivides the farm and offers the lots for sale he is creating an inventory of lots for sale in the regular course of that business. As a result, Dick has created an inventory of lots and is deemed to be in the business of selling them.  Even if Dick had not been in real estate sales before subdividing the farm and offering the lots for sale, the gain would still be ordinary income to Dick in most situations.

Section 1237 of the tax code creates an exception for the sales of small numbers of subdivided lots, but there are a number of hurdles to obtaining the benefits of capital gains rates.  For example, the person selling the lots must have owned the land for 5 or more years prior to subdividing the property and have made no substantial improvements on the property. While it is not possible to delve into this exception at length, readers should be aware of it and analyze the situation and the law carefully before relying on the exception.

The key message is, if someone subdivides land, the income from the sale of lots may be taxed at ordinary, as opposed to capital, gains rates.

What if Melvin (not a realtor) inherits a farm and contributes it to a partnership in which there is a realtor-partner?  If Melvin had sold the farm by himself he probably would have qualified for capital gains treatment, but by contributing it to a partnership with realtor-partners where the partnership engages in subdividing and selling lots, the partnership has an inventory of lots and any gain that Melvin receives from the partnership will be ordinary gain to him and the other partners.

For those focusing on obtaining capital gains treatment on the sale of real estate and other assets the question of “inventory” is critical, and there are many fact situations and gray areas that cannot be addressed in this newsletter. 

If you have further questions call The Tax and Business Professionals for assistance.

Copyright 2007
By Tax and Business Professionals, Inc.
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