1231 Assets
A little known rule may offer preferential tax treatment.
A number of real estate developers build or rehab distressed properties with the intention of holding them for the production of rental income. But subsequently, they may decide to sell all or a portion of a building or project, such as a partially completed development. Sometimes the sale occurs before
the project begins, during development, or shortly after completion. Can the entire gain or a portion of the gain on the sale of property qualify for preferential capital gain treatment even though the project has not been completed?
To the extent the assets sold are considered by the IRS as Section 1231 property - property used in a trade or business held over one year - the taxpayer would be eligible for preferential capital gain treatment. In the context of developing a commercial building, many practitioners believe that a building must meet the following requirements to qualify as 1231 property: completion of the entire building, held over one year after completion, and ready for occupancy for an entire year to be eligible for preferential capital gain treatment.
As detailed below, there are a number of different situations where self-constructed or purchased property could be considered Section 1231 property without meeting the general requirements discussed above.
Analysis
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 capital gain treatment. 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, this includes an example of a building under development sold prior to completion. Based on the ruling, the portion of the building completed and held over the applicable holding period is considered Section 1231 property.
This still begs the question as to when a portion of a building is completed. It appears that one must keep track of expenditures and the dates they incurred. In determining the 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 time period.
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 $200. The sale would be treated as the sale of a 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.
Planning Considerations
To facilitate qualifying for long-term capital gain treatment under Section 1231, a developer should keep detailed records, such as using construction draws, 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 alternate, 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 purchase and sales agreement 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.
Jennifer Seaton, CPA, is a tax partner in the Real Estate Group at McGladrey LLP. Contact her at jennifer.seaton@mcgladrey.com. Marlon Fortineaux, CPA, is tax senior manager in the Real Estate Group at McGladrey LLP. Contact him at marlon.fortineaux@mcgladrey.com.