Income Tax for Real Estate Developer

[Navid T.]

Hello Guys,

Let's assume I managed to purchase a land for $ 100 k and I build a 10 unit apartment complex ( construction cost = $ 900 k), and let's say it takes me 2 years to complete the project (The ROI is 100%). Then I decide to sell 5 units of this project and I net $500 k after all expenses, but I decide to keep the other 5 units for more than a year. As far as I'm aware, I have to pay regular income tax on the $ 500k. After a year, I decide to sell the rest of the units and I net another $ 500 k. Can I pay capital gain on this $ 500 k or I still have to pay regular income tax on it? (which is going to be about 20% based on my income tax bracket)?

Please clarify this scenario for me.

Thank You

[Michael Plaks]

@Navid T.

This is a great question, but it does not have a simple answer. It really needs an in-depth discussion with a tax expert specializing in real estate.

There is a major distinction between a developer and an investor for tax purposes:

Developer buys, subdivides, maybe builds and sells. He pays what you call regular income tax PLUS 15% self-employment tax (Soc Security/Medicare). Combined, it can be anywhere between 15% and 40%. Will be eligible for the new 20% deduction.

Investor buys, waits for time-based appreciation, usually rents, and ultimately sells. She pays long-term capital gains of 15% and no SE tax. (For full disclosure, the 15% can go up to 24% for higher-income folks.) In addition, she pays 25% on the depreciation recapture. Not eligible for the new 20% deduction.

The trick is determining whether the second part of your deal qualifies for the investor treatment. It is a grey area with many gotchas and a long history of litigation between taxpayers and the IRS. There're also some tax planning strategies designed to fortify your investor position. Like I said, this is not for a quick online answer.