Tax Treatment For Land Entitlement Strategy

Tax, SDIRAs & Cost Segregation
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Tax Treatment For Land Entitlement Strategy

Stuart UdisPro Member
Attorney · Philadelphia · Member since 2018 · 2k+ posts · 3k+ votes

I sat in on a webinar yesterday for a land development fund where the sponsors get land under contract with the intent of completing entitlements before finding a builder to acquire the property for horizontal & vertical development. The sponsor explained their process as merely holding the contract without ever settling on the land yet suggested the LP's who invested in the fund would receive long term capital gains treatment. Would love to hear from the tax professionals how this is possible. I was under the impression the land must be owned for over 1 year but intent is a second consideration as the IRS will take into account dealer vs. investor.  Thanks in advance

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Jay HinrichsBusiness Member
Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
11mo
Quote from @Stuart Udis:

@Chris Seveney My thoughts exactly. Tax treatment has such a significant impact. I was surprised they couldn't provide an explanation of why this fund would generate LTCG treatment despite asserting it would. Perhaps they thought the investors listening in would be so mesmerized by the excel slide showing the potential of a 5.8X multiple in a 3-5 year hold and 80%+ IRR they wouldn't sweat the small details :)


not a tax expert of course.. However It would be interesting to see if you have a contract and your entitling property you dont own and then you sell in less than a year ( which I would think would be pretty limited as entitlements take longer generally speaking) to me thats ordinary income from time and intent.  Going over a year but you still have intent? 

i know with folks I have worked with over the years to keep from dealer status they would get the plat ready but never record it. once recorded the thought is you now have inventory IE individual parcels. 

I have fund 3 of these types of deals in WA DC one closes Nov. And we have been in it about 18 months the other two we will be in them about the same. I am meeting my client and BP con starting tomorrow and will ask him what he plans to do.. We are just lenders so its ordinary for us but my client has BIG UPS and this would be critical for him tax wise. Will report back .
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  • Chris SeveneyBusiness Member
    Moderator
    Investor · VA · Member since 2015 · 21k+ posts · 19k+ votes
    11mo

    I am not a CPA or tax expert. Sometimes I like to think I know enough to get myself in trouble. I would love to see the tax opinion from their CPA or any CPA to show how this is not dealer activity as the entire intent as you mentioned is to sell the property and they have it under contract and do not own it. But even if they bought it to do the double closing that still appears to be acting as a dealer based on my interpretation. But again I am not a tax expert

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  • Stuart UdisPro Member
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    Attorney · Philadelphia · Member since 2018 · 2k+ posts · 3k+ votes
    11mo

    @Chris Seveney My thoughts exactly. Tax treatment has such a significant impact. I was surprised they couldn't provide an explanation of why this fund would generate LTCG treatment despite asserting it would. Perhaps they thought the investors listening in would be so mesmerized by the excel slide showing the potential of a 5.8X multiple in a 3-5 year hold and 80%+ IRR they wouldn't sweat the small details :)

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    • Jay HinrichsBusiness Member
      Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
      11mo
      Quote from @Stuart Udis:

      @Chris Seveney My thoughts exactly. Tax treatment has such a significant impact. I was surprised they couldn't provide an explanation of why this fund would generate LTCG treatment despite asserting it would. Perhaps they thought the investors listening in would be so mesmerized by the excel slide showing the potential of a 5.8X multiple in a 3-5 year hold and 80%+ IRR they wouldn't sweat the small details :)


      not a tax expert of course.. However It would be interesting to see if you have a contract and your entitling property you dont own and then you sell in less than a year ( which I would think would be pretty limited as entitlements take longer generally speaking) to me thats ordinary income from time and intent.  Going over a year but you still have intent? 

      i know with folks I have worked with over the years to keep from dealer status they would get the plat ready but never record it. once recorded the thought is you now have inventory IE individual parcels. 

      I have fund 3 of these types of deals in WA DC one closes Nov. And we have been in it about 18 months the other two we will be in them about the same. I am meeting my client and BP con starting tomorrow and will ask him what he plans to do.. We are just lenders so its ordinary for us but my client has BIG UPS and this would be critical for him tax wise. Will report back .
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  • Josh L.
    USA · Member since 2023 · 145 posts · 84 votes
    11mo

    @Stuart Udis Interesting question thanks for sharing, but not sure how this would qualify for a preferential rate under multiple scenarios.

    1. Held less than a year even if a capital asset it would still be taxed at ordinary rates.

    2. Not sure how this doesn’t qualify as dealer activity making this option or contract flipping all subject to ordinary rates as it seems the intent is clear. Intent has a long history through the courts and isn’t the most definitive and requires careful analysis but in this situation, on the surface, intent seems rather clear.

    3. Further, the code and regulations are clear that even with an option or contract it looks through the contract and looks at what the property would be if the taxpayer actually acquired it, that is, inventory in this case (ie not capital asset) so no preferential tax rate.

    In other words, I can’t see in your webinar scenario even if held longer than a year how it would qualify for preferential long-term rates given the facts. There could be some nuances that are not readily apparent. 

    I cite the minutiae below just for some authority to stand on. I would be curious if there were any authoritative sources provided and maybe I'm off. 

    Also, I would be curious of other tax experts’ opinions as well if I’m missing something. 

    Typical caveat - more specfic facts and circumstances prevail that may change the conclusion. 

    Section 1.1234-1 Options to buy or sell.

    (d) Dealers in options to buy or sell. Any gain or loss realized by a dealer in options from the sale or exchange of an option to buy or sell property is considered ordinary income or loss under paragraph (a)(3) of this section. A dealer in options to buy or sell property is considered a dealer in the property subject to the option.

    Example 3 from section cited above (not exact scenario but a loss; not sure they'd argue for preferential rate treatment here): A dealer in industrial property acquires an option to buy an industrial site and fails to exercise the option. The loss is an ordinary loss since the property would have been held for sale to customers in the ordinary course of his trade or business if he had acquired it. 

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  • Jason MalabuteBusiness Member
    Accountant · Los Angeles, CA · Member since 2016 · 2k+ posts · 901 votes
    11mo

    I completely agree with what Josh is saying here.

    He makes a great point that it’s difficult to see how this type of transaction could ever qualify for preferential long-term capital gains treatment. Even if the property or contract were technically held for over a year, it would still likely be taxed at ordinary income rates because the nature and intent of the activity look a lot like dealer activity (i.e., flipping or developing with the intent to sell).

    As Josh explains, the IRS and courts tend to focus heavily on intent and the taxpayer’s ordinary course of business. If the taxpayer’s intent was to sell for profit rather than to hold as an investment, it generally falls under ordinary income treatment. Section 1.1234-1(d) makes it clear that gains or losses from options or contracts connected to a dealer’s trade or business are treated as ordinary income, not capital.

    So I agree with Josh’s interpretation — even if the option or contract was held long enough to meet the “long-term” threshold, the underlying facts suggest it would still be taxed at ordinary rates because it’s more like inventory than a capital asset.

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  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    11mo

    @Stuart Udis 

    You’re right that land usually needs to be held for over a year for long-term capital gains with investor status. Even if they hold this for a year, there will be no capital gain treatment if they are considered a dealer.

    If the sponsor holds a contract for more than a year for the land and completes entitlements before selling, it’s possible for LPs to get long-term capital gains treatment, as long as the sponsor isn't considered a dealer (buying and selling frequently). 

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    This post does not create a CPA-client relationship. The information contained in this post is not to be relied upon. Readers are advised to seek professional advice.

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