Selling property originally constructed for use in a business
Certain real estate developers build or improve property with the intention of holding it for the production of rental income but subsequently decide to sell all or a portion of a building or project (e.g., a partially completed development). Sometimes the sale occurs before the project, or certain portions of the project, are placed in service. Can the property nevertheless qualify as property used in a trade or business? If the placed-in-service date is not material, how does one determine the holding period of property that is built or developed over an extended period of time? Must the entire project be held for the applicable holding period, or is there some other method of dividing the building or project into a portion that qualifies, and a portion that fails to qualify, for the applicable holding period? If the taxpayer’s holding period for the completed portion(s) of the project exceeds one year, the applicable assets could potentially be considered section 1231 assets, which are eligible for preferential capital asset treatment.
Somewhat surprisingly, the IRS takes the view that property is used in a taxpayer’s business if it is built or acquired for that purpose, even if it has not yet been placed in service and is actually sold by the taxpayer before it is placed in service. For example, Rev. Rul. 58-133 provides that real property purchased specifically for use in a taxpayer's business that was never in fact placed in service and was sold instead qualified for the favorable treatment of the predecessor to section 1231. The only requirement was that the holding period be satisfied, as between the purchase date and the sale date. The placed in service date is irrelevant.
That rule is easy enough to apply when property is purchased, but what about self-constructed property? Rev. Rul. 75-524 addresses the holding period for an office building that was newly constructed for use in the taxpayer's business and sold shortly after completion to an unrelated corporation. The ruling reflects the IRS position that the property does need to be placed in service to qualify as property used in a trade or business. As to the holding period of self-constructed property, the ruling explains:
In Fred Draper, 32 T.C. 545 (1959), acq. on another issue, 1960-2 C.B. 4, the Tax Court of the United States held that, for purposes of section 117(j) of the Internal Revenue Code of 1939, corresponding to section 1231 of the 1954 Code, the holding period of an asset begins on the date of acquisition and that such acquisition occurs progressively, in the case of a building under construction, as construction (erection) of the building is completed. Accordingly, the portion of the building sold by the taxpayer that was actually completed more than 6 months prior to the date of sale is held for more than 6 months for purposes of section 1231 of the Code.
What does it mean for a portion of a building to be completed? The ruling appears to treat the building as comprised of two separate assets: (1) the portion completed more than six months before the sale, and (2) the remainder. Thus, it explains that, “[t]he date of completion or actual use of the entire building is not controlling.” The ruling goes on to state that:
The facts in this case establish that 30x dollars was the basis of the portion of the building completed more than 6 months prior to the date of sale. Therefore, such portion, with a basis of 30x dollars, qualifies as “property used in the trade or business” under section 1231. The portion of the building completed 6 months or less prior to the date of sale is an asset held for 6 months or less and thus is not within the purview of section 1231.
This still begs the question as to when a portion of a building is completed. It appears that one must keep track of one’s expenditures and the dates on which they were capitalized. In determining holding period of an asset, one must allocate expenditures and proceeds between the portion of the asset that was deemed held greater than one year (in the case of a one-year holding period) and the other portion that was deemed held for a shorter period of time. Out of the total expenditures capitalized before the sale of the building, the percentage incurred more than one year before the date of sale is apparently treated as the percentage of (1) the total expenditures constituting the basis of the asset held for the holding period, and (2) the total sales price allocable to that portion. Thus, the same percentage of the total gain (or loss) on the actual, combined asset would appear to qualify for long-term capital gain treatment under section 1231. The remainder of the gain (or loss) would apparently be treated as short-term capital gain or loss.
For example, assume the total project cost $100, $30 of that was incurred more than one year before the date of sale, and the total project was sold for $200x. The sale would be treated as the sale of section 1231 property with a basis of $30 and an amount realized of $60, generating $30 of long-term capital gain, and the sale of other property, presumably constituting a capital asset, with a basis of $70 and an amount realized of $140, generating $70 of short-term capital gain.
Allocation of proceeds
Where multiple assets or properties are sold in a single transaction or a series of related transactions, the allocation of proceeds typically follows the allocation outlined in the purchase and sale agreement (PSA). If the PSA does not provide for an allocation, a relative fair market value approach may be employed.
In addition to the character issue described above, the allocation of proceeds on the sale of real estate is extremely important due to the potential recapture of depreciation on the sale of section 1231 property and the tax rate differentials arising under the recapture rules of section 1250. These issues would arise only if the property had been placed in service before its sale. However, even in that case, the holding period of various portions of the property would be very important.
To facilitate qualifying for long-term capital gain treatment under section 1231, a developer should keep detailed records (i.e., using construction draws, etc.) for all phases of a project to support the allocation of costs to various components of the project and to determine the aggregate percentage of the project costs incurred as of various dates. In addition, although Rev. Rul. 75-524 cited above seems to allow a strictly mathematical bifurcation of a project into long-term and short-term portions based on the timing of expenditures, it may be important to have an alternative, less abstract argument that various segments, sections or units of a larger project were completed more than one year before the sale date. For example, a PSA might include a breakdown between the different phases or aspects of the project and might provide for inspections, sign-offs or other indicia of “completeness.” Periodic appraisals of the “value” as of any particular to date, in addition to the expenses incurred through that date, might also be helpful.
Although this discussion has focused on real estate development, similar issues could arise with other self-constructed assets with long construction periods, such as an airplane intended for lease, where there is a potential for the taxpayer to change his plans and sell property that was originally intended for use in his trade or business.
REITs are becoming increasingly popular, but along with many valuable benefits come strict compliance rules that must be considered.
There are certain opportunities for favorable capital gain treatment in phased real estate development projects.
In recent years, the IRS has significantly increased efforts to enforce international tax reporting and withholding obligations.
Varied taxable income can lead to fluctuations in the real estate life cycle. Minimize exposure to phantom income with these considerations.