Case of the Week
Exit Strategies for Real Estate Investors, Part 10
Case:Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. By far, Karl was most successful with real estate investments. It was definitely his passion.
Amazingly, Karl continued to buy and sell real estate at the age of 85. For instance, about three months ago, Karl discovered a great investment property. It was a "fixer-upper" commercial building in a great area. While other nearby buildings sold for over $2 million, the seller needed to sell quickly and was asking just $1 million.
The condition of the building turned many buyers away. It was being sold "as-is," but Karl was not deterred. He could see great potential with the building and knew it would not take much to get it to market condition. Therefore, Karl swooped in, bought the building for $1 million and instantly hired contractors to refurbish the place.
After three months of hard work refurbishing the building, the place looked like new! In the end, Karl invested $250,000 in the building, bringing his total investment in the property to $1.25 million. One month after the completion of the work, Karl was contacted informally by a company that expressed an interest in the building – a $2 million interest! This was no surprise to Karl. He knew the building was another great buy.
There was one downside to the idea of selling – the big tax bite on Karl's gains. However, after Karl learned about the benefits of a FLIP CRUT, he eagerly wanted to move forward. It looked like the perfect solution. (See Part 1 for this discussion.) However, there was still one question in Karl's attorney's mind.
Question:Given Karl's real estate investment activity over the years, could the Service argue that Karl is a developer or dealer of real estate? More importantly, could the Service win on this argument? What is the downside if Karl is classified as a developer or dealer?
Solution:The key issue is the tax treatment of the sale of the building. If Karl is deemed a developer or dealer of real estate with respect to this property, he will face ordinary income taxation upon sale of his property, not capital gains. In the event Karl – as a developer or dealer – decides to transfer his property to a charitable remainder trust (CRT), the ordinary income component of the property will be allocated to tier one of the CRT after the sale of the property. In addition, if the property is not a capital gain-type property, the charitable deduction reduction rules will apply resulting in smaller tax savings. See Sec. 170(e) and Case Study Part 2. Lastly, it will be important to not generate any unrelated business income (UBI) while the property is held inside the trust.
Based upon the above, it is preferable for donors to hold property as long-term capital gain property as opposed to ordinary income property. Nevertheless, the use of ordinary income property is still beneficial in the right circumstances. For instance, the use of ordinary income property still avoids tax on the sale of the property inside the trust and produces a charitable income tax deduction based upon the donor's cost basis.
In this case, Karl is a general investor – art, real estate and stocks – with particular success in real estate investing. He purchases individual pieces of property about every three to five years and usually holds the property for five years or longer. The most common use of the property during the holding period is rental in nature.
Therefore, based upon his infrequent purchases, rental property usage and lack of any development of the property, it is very unlikely the Service can successfully argue that Karl is a developer or dealer in real estate. Indeed, a person who buys and sells one property every three to five years should not rise to developer or dealer status. Conversely, developers and dealers are actively engaged in buying, developing and selling – usually with large volumes and great frequency. As a result of these findings, Karl's attorney feels confident that Karl is not a developer or dealer for income tax purposes.