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hello, My wife and I as individuals just closed 2 weeks ago

Customer Question
on a real estate property...
hello, My wife and I as individuals just closed 2 weeks ago on a real estate property (land) and we are selling it next week to another couple. I have a real estate sale agent license in Texas, however I only practice once in awhile for myself. I began this transaction to see if I wanted to re-enter the real estate investment arena to have another source of income. My questions are regarding federal tax consequences regarding this real estate transaction and others in the future. This sale will net me a profit which I assume will be a short term capital gain. Should I quickly structure a LLC or any other business structure that would make the tax consequence less. I already have a Sub S Corp. that is a construction company that has been in business 25 years, should I use it in the future? Are trusts a better way to buy and sell real estate? I may want to hold a property as a rental property before selling it. Is there one structure best for all these scenarios?

thanks, Dale
Submitted: 7 years ago.Category: Tax
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7/2/2010
Tax Professional: BK-CPA, Certified Public Accountant (CPA) replied 7 years ago
BK-CPA
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Properties that you develop are capitalized as inventory under IRC 263A. They are taxed as ordinary income when sold generally, not capital gains. Ordinary income can be shielded to some extent from self-employment tax using an S-Corp, yes.

 

A real estate professional (IRC 469 off the top of my head) is one that spends more than 750 hours a year in real estate, but also that spends more than half their time in real estate. A real estate professional pays self employment tax and files on Schedule C all income from rental properties, which could otherwise be subject to passive loss rules and rental treatment on Schedule E.

 

If we assume you have a capital gain, then it's irrelevant whether or not you recognize that gain in an S-Corp or directly (it will flow through to you anyways, generally speaking).

 

As a real estate professional, an S-Corp might work out, but personal service S-Corps are under some scrutiny, so let them finish the legislation (late this year) and make sure it wouldn't apply to you before forming a real estate S-Corp.

 

A C-Corp or trust (your other general options) are generally not necessary for someone in the real estate business. C-Corps are tough on passive income and create double taxation. Trusts tend to complicate real estate transactions unless done correctly, but really don't apply to properties that are inventory to a developer and/or being actively rented to the extent there is a proper business entity set up and the trusts are not being used for legal / estate reasons.

 

Holding a rental property will lead to you depreciating that property before converting and selling it. If you are in the business of development and/or real estate sales, then your capital gains on the sale of a rental could potentially be challenged by the IRS as being ordinary income, as a practical observation.

 

If there is something else that comes to mind, let me know, but it sounds like you definitely are not going to want to set up a business for the land sale only. Do it if you are going to stay in real estate. An LLC is common and a good start, but LLC's (state entities) are allowed to elect S-Corp status (IRS entity), so you can have an LLC / S-Corp if you like.

 

Thank you for your question.

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Customer reply replied 7 years ago
I need a little bit of clarification, please.

You stated "Properties that you develop are capitalized as inventory under IRC 263A."

My primary investment objective is to buy properties either land (vacant) or houses through forecloseure sales and resell them as I am doing on the above described land deal.
When you speak of inventory does it matter how long the time span between when I buy the property and when I sell it. In this case I will own it less than 1 month. That was my thinking behind it being short term capital gain.So basicly what defines inventory?

My rental thesis applies only as a back up plan if I were to aquire a house that I could not resell quickly and needed to rent it for a while to generate income.

The idea of a LLC or just keeping the deals under my current S Corp. is praimarly for lability reasons. The S Corp is a construction company and yes I have built homes in the past as well a commerical contracting over 30 years.
Tax Professional: BK-CPA, Certified Public Accountant (CPA) replied 7 years ago

Let's start by taking a look at 263A:

 

http://www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00000263---A000-.html

 

§ 263A. Capitalization and inclusion in inventory costs of certain expenses

How Current is This?

(a) Nondeductibility of certain direct and indirect costs

 

(1) In general In the case of any property to which this section applies, any costs described in paragraph (2)-

(A) in the case of property which is inventory in the hands of the taxpayer, shall be included in inventory costs, and

(B) in the case of any other property, shall be capitalized.

 

(2) Allocable costs The costs described in this paragraph with respect to any property are-

(A) the direct costs of such property, and

(B) such property's proper share of those indirect costs (including taxes) part or all of which are allocable to such property. Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.

 

 

 

(b) Property to which section applies

Except as otherwise provided in this section, this section shall apply to-

 

(1) Property produced by taxpayer Real or tangible personal property produced by the taxpayer.

 

(2) Property acquired for resale

(A) In general Real or personal property described in section 1221 (a)(1) which is acquired by the taxpayer for resale.

(B) Exception for taxpayer with gross receipts of $10,000,000 or less Subparagraph (A) shall not apply to any personal property acquired during any taxable year by the taxpayer for resale if the average annual gross receipts of the taxpayer (or any predecessor) for the 3-taxable year period ending with the taxable year preceding such taxable year do not exceed $10,000,000.

 

 

.....

 

 

 

 

Property that you produce must be capitalized according to 263A(b)(1). Property that you purchase for resale is covered under 263A(b)(2). Note the exception to properties acquired for resale when gross receipts are less than $10,000,000 on average (allows you to expense everything as an ordinary business deduction up front, but only for personal property, not real property).

 

Also, the reference to 1221(a)(1) for resale property refers to the definition of a capital asset, which under 1221(a)(1) does not include inventory, under 1221(a)(2) does not include depreciable items (inventory is not depreciable, btw), and under 1221(a)(8) does not include things like supplies consumed in the business regularily.

 

Because you are purchasing for resale and/or developing for resale, these amounts aren't typically going to be treated as capital gains (inventory is ordinary income property, and you've got a real estate license and a construction company...). Capitalizing these amounts and holding them would allow for investment treatment (capital gains).

 

Note that land is never depreciated, just buildings on the land, and only if those buildings are being rented or otherwise used, not held for resale.

 

Perhaps you can go ahead and claim your land sale as a capital gain (short term)... there are two more sections I would like you to read if you care to. The first one is shorter:

 

http://www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00001237----000-.html

 

§ 1237. Real property subdivided for sale

How Current is This?

(a) General Any lot or parcel which is part of a tract of real property in the hands of a taxpayer other than a C corporation shall not be deemed to be held primarily for sale to customers in the ordinary course of trade or business at the time of sale solely because of the taxpayer having subdivided such tract for purposes of sale or because of any activity incident to such subdivision or sale, if-

 

 

 

 

There is also Section 469, which describes what an active real estate professional is:

 

http://www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00000469----000-.html

 

....

 

(7) Special rules for taxpayers in real property business

 

(A) In general If this paragraph applies to any taxpayer for a taxable year-

(i) paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and

(ii) this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity. Notwithstanding clause (ii), a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.

 

(B) Taxpayers to whom paragraph applies This paragraph shall apply to a taxpayer for a taxable year if-

(i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

(ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

 

 

 

 

.....

 

 

 

 

If you buy and sell land, without doing anything to it, and make a profit, then you've got a stronger case for capital gains treatment on your 1040, Schedule D (short term capital gains don't necessarily help anyways though, as they are taxed as ordinary income generally speaking).

 

See this website for a nice explanation of capital gains:

 

http://taxes.about.com/od/capitalgains/a/CapitalGainsTax_4.htm

 

 



Edited by BK-CPA on 7/7/2010 at 1:54 PM EST
BK-CPA
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Customer reply replied 7 years ago
I apologize for getting you paid so late. I had a brother who has been ill for a long time take a turn for the worse while we were corresponding. I had to leave town and then last week he passed away. I just got back home to where I could take care of this.

Thank you for your help.

Dale
Tax Professional: BK-CPA, Certified Public Accountant (CPA) replied 7 years ago
Thank you! Good luck to you as well.
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