Selling Appreciated Land? Use the S Corporation to Lock in Favorable Capital Gains Treatment

Real estate values have surged in many parts of the country and are still surging in some areas. That’s good news if you’ve been holding raw land for investment.

You might be ready to cash in by subdividing and developing your acreage and selling off parcels for big profits.

Great, but what about taxes?

Good question, because there’s a big issue to consider.

The Tax Issue

When you subdivide, develop, and sell land, you’re generally deemed for federal income tax purposes to be acting as a dealer in real property who is selling off inventory (developed parcels held for sale to customers).

That’s not good, because when you’re classified as a dealer for tax purposes, all of your profit from land sales—including the part attributable to pre-development appreciation in the value of the land—is considered ordinary income. So, it’s taxed at your regular federal rate, which (for now) can be up to 37 percent.

You may also get hit with the 3.8 percent net investment income tax (NIIT), which (for now) can push the effective federal rate up to as high as 40.8 percent (37 percent + 3.8 percent). Ugh!

Seeking a Better Tax Result

It sure would be nice if you could pay lower long-term capital gains rates on at least part of your land sale profits.

For now, the maximum federal rate on long-term capital gains is 20 percent. With the 3.8 percent NIIT added on, the maximum effective rate (for now) is “only” 23.8 percent (20 percent + 3.8 percent). That’s a lot better than 40.8 percent.

Fortunately, there’s a way to qualify for favorable long-term capital gain treatment for the pre-development land appreciation, assuming you really and truly have held the land for investment.

In other words, this assumes you’re not already classified as a real property dealer.

But profits attributable to the later subdividing, development, and marketing activities will be considered ordinary income collected in your capacity as a real property dealer. Oh well.

Since pre-development appreciation is often the biggest part of the total profit, you should be overjoyed to pay “only” 20 percent or 23.8 percent on that piece of the action. The rest of this article explains a way to achieve this tax-saving goal.

Form an S Corporation to Function as a Developer Entity

Say you form a new S corporation.

Then you sell your appreciated raw land to the S corporation for its pre-development fair market value (FMV). Great idea! As long as you’ve

• held the land for investment rather than as inventory as a real property dealer, and
• held it for more than one year,

then the sale to the S corporation will qualify for lower-taxed long-term capital gain treatment.

So, for now, you’ll lose (at most) “only” 23.8 percent of your whopping long-term gain to the feds.

After buying the land from you, the S corporation then subdivides and develops the property, markets it, and sells it off. The profits from these activities are ordinary income that’s passed through to you and taxed at your personal rates.

But this is a great tax-saving deal when the land is highly appreciated to start with.

To sum up so far, the S corporation developer entity strategy allows you to lock in favorable long-term capital gain

treatment for the pre-development appreciation of the land while paying higher ordinary income rates only on the additional profits from development and related activities. Good strategy.

Consider an Installment Sale to the S Corporation

If necessary, you can sell the appreciated land to the S corporation developer entity for a bit of cash plus a lot of installment notes owed by the S corporation to you.

That way, you can defer the taxable gain from selling the land to the S corporation until you receive principal payments on the notes. But installment sales have some potential tax disadvantages to consider:

• Deferring taxable gain by using installment sale reporting won’t turn out to be very smart if our beloved Congress jacks up the maximum long-term gain rates before you collect all your notes from the S corporation. Needless to say, that could happen! For this reason, you may be well-advised to elect out of installment sale reporting in order to lock in lower current long-term capital gains tax rates—as long as they last.
• If you nevertheless choose to use installment sale reporting, the so-called second disposition rule will trigger deferred gains attributable to land sold by the S corporation within two years after buying it from you. So, the deferred tax bill could come due sooner than you expect.
• If you make a big installment sale to the S corporation, you could fall under the installment sale interest charge rule. In that event, you must pay interest to the feds on at least part of the deferred federal income tax bill.

Advice. All things considered, it might be best to elect out of installment reporting and simply pay the 20 percent or 23.8 percent (for now) federal income tax hit on the front end. If necessary, borrowing enough money to do so and incurring the resulting interest expense could be worth it, especially if interest rates stay low.

Make Sure the Developer Entity Is an S Corporation

The developer entity strategy should work just fine as long as you make the developer entity an S corporation rather than a controlled partnership or a controlled multi-member LLC that’s treated as a partnership for federal tax purposes.

Why? Because a little-known provision mandates high-taxed ordinary income treatment for gain from a sale to a controlled partnership or to a controlled LLC that’s treated as a partnership for tax purposes, when the asset in question is not a capital asset in the hands of the partnership or LLC.

Since the land in your situation would not be a capital asset in the hands of a controlled partnership or LLC— because the partnership or LLC would be classified as a dealer in real estate—the sale would result in high-taxed ordinary income for you. That would defeat the purpose of the whole developer entity exercise.

So, use an S corporation as the developer entity. Don’t use a controlled partnership or a controlled LLC treated as a partnership.

Also, don’t use a C corporation as the developer entity, because that could result in double taxation of the profit from subdividing and developing the land.

Plan Ahead to Negate IRS Objections

Finally, be aware of two potential IRS arguments against the S corporation developer entity strategy—and plan to defeat them.

1. How to Defeat the Capital Contribution Argument

The IRS might argue that what actually happened here was a capital contribution by you of the appreciated land to the S corporation developer entity, followed by development and sales activities. If successful, this argument would result in the entire profit being treated as ordinary income recognized by the S corporation and then passed through to you to be taxed at higher rates. Ugh!

The good news: in Bradshaw, the taxpayer beat the IRS on this very issue.

Even so, the moral of the story is to carefully document and execute the sale between you and the S corporation developer entity.

• If installment notes are involved, be sure the interest and principal get paid according to the terms of the notes.
• Do all the other things that indicate a sale rather than a capital contribution.
• Make sure the formation and capitalization of the S corporation and the sale of the land to the S-corporation are completely separate and distinct events.
• Get the land appraised before the sale to the S corporation, and charge FMV.
• Don’t let the S corporation issue any stock to you at the same time the land sale is made.
• Yada, yada, yada.

You get the idea. And to avoid pitfalls, you should get your tax advisor involved in the process.

2. How to Defeat the Agency Argument

The IRS could argue that the S corporation developer entity is actually just acting as your agent.

If this argument were successful, your purported sale of the land to the S corporation would be completely disregarded for federal income tax purposes. You would fall into real property dealer status, and all the profit would be high-taxed ordinary income for you.

But in Bramblett, the Fifth Circuit rejected this agency argument, even though there were some “bad facts” in that case. Still, the moral of this second story is that you need to clearly separate your affairs from the S corporation developer entity’s affairs. That will defeat any agency argument by the IRS.

Takeaways

Regardless of what happens with future individual federal income tax rates, the S corporation developer entity strategy explained here is beneficial when you have significant profit from the pre-development appreciation and there’s a big difference between ordinary income rates and long-term capital gains rates.

You need to do this correctly. Executed properly, the strategy should be above reproach if you ever get audited on the issue. Key words: executed properly. Get your tax advisor involved to avoid missteps. It will be money well spent.

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