Real estate agents, developers and investors must be careful in how they report income from the sale of subdivided real property. Many taxpayers and preparers assume the sale of real estate is eligible for capital gains treatment (capital gains are currently taxed at 15% for federal purposes) as opposed to ordinary income (current maximum federal rate of 35%). Needless to say an IRS adjustment relating to these issues and the addition of penalties and interest oftentimes results in a large liability that perhaps could have been minimized or avoided with proper planning.

In determining the proper tax treatment on the sale of subdivided property one has to consider whether the property constitutes investment property, which is eligible for capital gains treatment, or property held primarily for sale in the ordinary course of the taxpayers trade or business (taxpayer is deemed a dealer in property), which is treated as ordinary income. Of course, most disputes between a taxpayer and the IRS relate to the determination and definition of a trade or business and therefore whether a property is an investment activity or held primarily for sale.

Whether property is held primarily for sale in the ordinary course of business or for investment depends upon the facts and circumstances present. Perhaps the circumstances indicate a property is held primarily for sale, but other facts and circumstances may indicate the taxpayer is not engaged in a trade or business. Some of the relevant facts considered by the IRS and Courts include:

1. The nature and purpose of the acquisition of the property and the duration of ownership;2. The extent and nature of sales efforts;3. The number, continuity, and regularity of sales;4. The extent to which the taxpayer attempts to increase sale by improving the property and advertising;5. The use of a business office to facilitate sales; and 6. The time and effort devoted to sales by the taxpayer.

The purpose for which the taxpayer acquired the property is an important consideration in determining the characterization of the property. However, it is not uncommon for property acquired for investment to later be characterized as property held for sale, if the facts and circumstances of the scenario change, sometimes over the course of many years.

The extent and nature of sales efforts is another consideration in properly characterizing these types of transactions. If the taxpayer engages in advertising, hires agents, maintains a sales office, has a real estate license or represents to the public himself as a dealer in property, it is likely the IRS would consider the taxpayer a dealer.

Another significant consideration is the number, continuity, and regularity of sales. Obviously, the more sales the taxpayer engages in , the greater the chance the IRS would consider the taxpayer a dealer. In addition, substantial development or improvement of a property, such as land improvements, grading, subdividing and installing roads or utilities indicate the taxpayer is a dealer.

In considering these factors it is important to note that not any one consideration is a determining factor – all considerations need to be weighed together in order to support a proper determination. In addition, the Internal Revenue Code provides for safe harbor provisions that allow investors to subdivide unimproved land into parcels and to sell the parcels without being deemed to have held the property primarily for sale in the ordinary course of a trade or business. However, these safe harbor provisions are limited and are not applicable if the taxpayer makes improvements to the property that substantially increase its value. Also, the safe harbor provisions are not available to dealers in real estate who hold property primarily for sale in the ordinary course of their trade or business.

The case of Hospital Corp. of America v. Commissioner of Revenue established the right of taxpayers to utilize cost segregation studies for computing depreciation and provides guidance in identifying tangible personal property in a building, which is eligible for accelerated methods of depreciation over fewer years as compared to the traditional 27.5 year recovery period for residential rental property and the 39.5 year recovery period for commercial real estate.The result of cost segregation analysis is significant savings to the taxpayer, and an incentive for investment, particularly when the taxpayer has the ability to elect the provisions of code section 179, which allows expensing (to a limit) of certain depreciable items all in one year.

The determination of whether an item is personal property or real property (ie: a structural component), as usual, depends upon the facts and circumstances, however, the IRS position is that the following items, if used in the operation and maintenance of a building are examples of structural components (ie: real property): bathtubs, boilers, ceilings, central air conditioning and heating systems, chimneys, doors, electrical and wiring, fire escapes, floors, hot water heaters, HVAC units, lighting fixtures, paneling, partitions – if not readily removable, plumbing, roofs, sinks, sprinkler systems, stairs, tiling, walls, and windows (Reg. Section 1.48-1(e)(2))

Here is a common scenario: A shareholder of a corporation rents property to his corporation, in which he materially participates (maybe a builder, landscaper, consultant, etc.), and earns a profit on the rental activity. In addition, the shareholder also owns other rental property that is reporting a loss for tax purposes. In several cases we have seen the taxpayer utilize the losses of one property to offset the gain from the other property.The problem with that strategy is the so-called self rental rule discussed under regulation 1.469-2(f)(6) of the IRS. Under this rule, if a shareholder rents property to his corporation in which he materially participates, at a profit, the profit is not considered passive income and therefore cannot be offset by losses from other activities (including other rentals) that are passive. These regulations were recently upheld by the Ninth Circuit as constitutional in the case of Beecher v. Commissioner, No. 05-71894 (9th Cir. – 3/23/2007)