Tax strategies for highly appreciated undeveloped land

Editor: Robert Venables, CPA, J.D., LL.M.

Undeveloped land may offer landowners opportunities for significant economic gain. Common monetization strategies for undeveloped land include development, sale to a developer, or subdivision into smaller parcels for individual sale. Each of these options can yield substantial profits, and proper planning and execution of the strategy chosen with respect to undeveloped land will allow a taxpayer to maximize the after–tax proceeds from the land’s disposition.

Income characterization

A key element of any effective tax strategy is income characterization. Qualifying for long–term capital gains, as opposed to ordinary income, on a transaction can result in significant tax savings due to the rate differential. Given the complexity often found in real estate transactions, how can taxpayers achieve this favorable treatment? The answer lies in careful tax planning and compliance and in understanding how the IRS classifies different types of real estate activities.

Initial planning

The first critical distinction in tax planning for undeveloped property is whether the taxpayer is classified as an investor or a dealer. This classification is fundamental, as it directly affects how profits are taxed. Real estate dealers — those who hold property primarily for sale to customers in the ordinary course of a trade or business — face significant challenges in qualifying for long–term capital gain treatment (Regs. Sec. 1.1221–1(b)). In contrast, investors typically realize gains from the appreciation in value of undeveloped land over time and benefit from a more favorable tax structure (see Gillette Motor Transport, Inc., 364 U.S. 130 (1960)). However, they must still exercise caution in their dealings not to inadvertently trigger ordinary–income treatment.

In Bramblett, 960 F.2d 526 (5th Cir. 1992), the Fifth Circuit found three principal questions that must be answered when analyzing whether sales of land are considered sales of a capital asset or of property held primarily for sale to customers in the ordinary course of a taxpayer’s business:

1. Was the taxpayer engaged in a trade or business, and if so, what business?
2. Was the taxpayer holding the property primarily for sale in that business?
3. Were the sales contemplated by the taxpayer “ordinary” in the course of that business?

Looking at other cases, including Graves, 867 F.2d 199 (4th Cir. 1989), and Musselwhite, T.C. Memo. 2022–57, the Fifth Circuit identified eight factors to be used in answering these questions:

• The purpose for which the property was acquired;
• The purpose for which the property was held;
• Improvements made to the property and their extent;
• Frequency, number, and continuity of sales;
• Extent and substantiality of the transaction;
• Nature and scope of the taxpayer’s business;
• Level of advertising; and
• Whether the property was listed for sale directly or through a broker.

No single factor is conclusive. For undeveloped land, taxpayers should try to establish a clear and consistent pattern that supports their intent to hold the property as an investment. In Malat v. Riddell, 383 U.S. 569 (1966), the Supreme Court held that “primarily” in Sec. 1221 means “of first importance” or “principally,” emphasizing that the taxpayer’s primary intent is key in determining whether the taxpayer is a dealer or an investor. In Suburban Realty Co., 615 F.2d 171 (5th Cir. 1980), the Fifth Circuit explained that frequent and substantial sales typical of a business indicate dealer status. The Tax Court expanded on these ideas in Little, T.C. Memo. 1993–281, stating:

The taxpayer’s primary purpose for holding property at a particular time is subject to change. Therefore, in determining the taxpayer’s purpose for tax treatment, the focus is on the time of the sale. … However, we may consider events over the course of the ownership to determine the primary holding purpose at the time of the sale.

Maintaining proper documentation and engaging in early planning are essential to establish taxpayers’ intent if the IRS examines the transaction. Factors that taxpayers should consider upfront in establishing an investment intent include:

• Whether the property will be held directly or through an entity;
• Whether the property will be segregated or commingled with other holdings;
• How the property is recorded in the taxpayer’s books and records; and
• Whether reported income or expenses align with the stated investment intent.

Careful attention to these factors strengthens the taxpayer’s position in claiming investment intent and mitigates audit risk.

Capturing long-term capital gains through sale to an S corporation

Once the property has been held for the requisite period, taxpayers may seek to capture its appreciation as long–term capital gain. A direct sale of land to a third party — without subdividing or improving it — usually supports an investment intent. However, a taxpayer’s subdividing or improving the land may suggest to the IRS that a shift to activity in the ordinary course of business has occurred, which could result in a change in classification of the taxpayer from investor to dealer, causing ordinary–income treatment to apply to the land’s sale.

One potential strategy to avoid this outcome is to sell the appreciated land to a corporation before any development occurs and allowing the corporation to handle the land’s development. This approach allows the taxpayer to recognize capital gain up to the time of sale to the corporation. The corporation’s basis in the property equals the purchase price (Sec. 1012(a)), adjusted for capitalized development costs (Sec. 1016(a)). Although future gains will be characterized as ordinary income, only the appreciation after the sale to the corporation will be affected.

Why does the buyer need to be a corporation? Under Sec. 707(b)(2), sales between a partnership and a partner owning more than 50% of the partnership or two partnerships in which the same persons own more than 50% of each partnership will result in ordinary income to the seller if the property is not a capital asset in the hands of the buyer. Using a corporation, as opposed to a partnership, avoids this recharacterization. While other related–party rules apply to corporations, such as Sec. 267(a)(1) (which denies losses from sales between related parties) and Sec. 1239 (which recharacterizes gain from sale of depreciable property), neither affects this scenario because the seller is incurring a gain, not a loss, and the property being sold is not depreciable.

Generally, taxpayers prefer the buyer to be an S corporation because C corporations are subject to double taxation. However, due to the restrictions in Sec. 1361 on an S corporation’s number and types of eligible shareholders, an S corporation may not always be an option. The remainder of this discussion assumes an S corporation structure.

To minimize the risk that a sale to an S corporation is challenged by the IRS, it is important that the taxpayer not only document the transaction as a sale but also observe the formalities of a sale, as the taxpayer did in Bradshaw, 683 F.2d 365 (Ct. Cl. 1982). In this case, the IRS attempted to recast a sale to an S corporation by its individual owner as a Sec. 351 capital contribution.

The IRS’s attempt to recharacterize the transaction was unsuccessful due to the owner’s adherence to formal sale procedures. As addressed in Bradshaw, “The proper characterization of a transaction … is a question of fact to be decided as of the time of the transfer on the basis of all of the objective evidence.” The court added, “While the form of the transaction is relevant, we are required to examine all of the pertinent factors in order to determine whether the substance of the transaction complies with its form.” The court concluded after reviewing the facts in the case that the sale price reflected the land’s fair market value, and sale formalities were strictly observed, so the owner had properly treated the transaction as a sale.

Example: A purchased undeveloped land five years ago for $100,000, with the intent to hold it as an investment. A has received unsolicited offers of $1 million but believes that the land could sell for $2 million if subdivided and improved at a cost of $500,000. Assume A’s tax rates are 37% for ordinary income and 23.8% for capital gains, which includes the 3.8% net investment income tax.

Option 1: Sell the undeveloped land: A would receive $1 million in cash and recognize $900,000 of long–term capital gain ($1 million proceeds less $100,000 basis), resulting in tax of $214,200 ($900,000 × 23.8%). A would be left with after–tax proceeds of $785,800.

Option 2: Develop the land before sale: If A were to develop the land at a cost of $500,000, A would receive $2 million in cash and recognize $1.4 million of income ($2 million proceeds less $600,000 basis). If these activities were deemed to be ordinary business activities, the income would be ordinary, and the resulting tax would be $518,000 ($1.4 million × 37%). A would be left with after–tax proceeds of $1,482,000 before factoring in the additional $500,000 of development costs. After factoring in these costs, A would have $982,000 of proceeds remaining.

Option 3: Sell the land to S corporation prior to development: A could form a corporation, Developer Corp. (DC), which would elect S corporation status. A would then sell the land to DC for $1 million, recognizing a long–term capital gain of $900,000 ($1 million proceeds less $100,000 basis). DC would then develop the land and sell the property for $2 million, realizing ordinary income of $500,000 ($2 million proceeds less $1.5 million basis).

The tax on the long–term capital gain would be $214,200, calculated the same as in Option 1, while the tax on the ordinary income would be $185,000 ($500,000 × 37%), resulting in a total tax of $399,200. A would be left with after–tax proceeds of $1,600,800 before development costs. After factoring in the $500,000 of development costs, A would have $1,100,800 of proceeds remaining.

By selling the land to DC prior to development, A can increase their after–tax proceeds by $315,000 compared with simply selling the undeveloped land, and by $118,800 compared with developing the land directly. This illustrates how timing and structuring can significantly affect the after–tax outcome, even when the underlying asset and sale price remain the same.

Additional considerations

While this strategy offers the benefit of favorable tax rates, it can accelerate the timing of when tax becomes due. One possible approach to defer some of the gain recognition is to structure the sale as an installment sale. Sec. 453(b)(1) defines an installment sale as “a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs.”

A detailed discussion of the installment method is beyond the scope of this item; however, in general, the method allows a taxpayer to limit the gain recognized in any year to the amount of payments received in that year multiplied by the gross profit ratio (Sec. 453(c)).

Any terms outlined in the installment note must be followed — this includes applying an appropriate interest rate and adhering to the stated payment schedule. It is important to note that dealers are not eligible to use the installment method under Sec. 453(b)(2).

As always, it is essential when selling undeveloped land that taxpayers engage in early and thorough planning and consult with qualified tax professionals. Real estate transactions, particularly those involving contracts or related–party sales, are complex and subject to heightened scrutiny. With careful planning and full compliance, taxpayers, with the help of a trusted tax adviser, can reduce tax liability while maximizing the economic potential of their investments.

Editor

Robert Venables, CPA, J.D., LL.M., is a tax partner with Cohen & Co. Ltd. in Fairlawn, Ohio.

For additional information about these items, contact Venables at rvenables@cohencpa.com.

Contributors are members of or associated with Cohen & Co. Ltd.