Published: 03/01/2007
Real estate investors often enter the development process consumed with the ups and downs of the "entitlement" process. Land-use battles are time-consuming, costly, and, in some cases, can turn into a full-contact sport.
But a singular entitlement focus can distract from other critical issues. Tax planning is often overlooked. By keeping perspective, real estate investors can introduce valuable tax-reduction strategies into real estate developments. One such tax technique is "land banking."
An Introduction to Land Banking
Although not widely known, land banking is the process of breaking real estate activities into discrete pieces performed by different business entities. Some entities perform investment functions while others engage only in development activities.
Why use multiple entities? The answer lies in the federal income tax rate structure. Land banking maximizes capital gains and reduces ordinary income. For several years, the federal income tax law encouraged long-term capital gain structures with the favorable tax rate of 15%. In May 2006, Congress extended the 15% capital gains rate through 2010.
Tax Planning During the Development Process
Many real estate investments start simply with an investor purchasing raw land. From this initial acquisition, the landowner may turn to the local planning office and begin the entitlement process. With their focus on the planning process, many investors do not realize that at some point in this process, a critical transformation occurs: the purpose for holding the real estate changes from an investment purpose to a developer or "dealer" purpose.
Developer or dealer activities produce ordinary income, but long-term investment returns are taxed at favorable capital gains rates. Real estate developers readily accept ordinary income for their development efforts. By ignoring the transformation to dealer activity, all gains are attributable to developer activities. All gains are taxed at ordinary tax rates that can reach 35%.
By land banking, the real estate owner "freezes" the investment returns and preserves capital gains. This freeze is achieved by selling the property to a separate controlled entity, which in turn develops and markets the entitled or platted lots to home or commercial builders.
Judicial Land Banking Support
About 15 years ago, the land banking technique received a major judicial endorsement. In 1992 the Fifth Circuit upheld capital gains treatment earned by land banking. With this decision the court supported capital gains even though the property was sold to a commonly controlled developer entity.
The 1992 case, Bramblett v. Commissioner, involved a Texas real estate development project in which four individuals formed a joint venture that purchased property for investment purposes but refrained from making physical improvements to the land. Several months later, these same four individuals also formed a corporation. Subsequently, the joint venture sold the real estate to the corporation. The corporation developed the property and sold off platted lots. The selling joint venture treated the sales proceeds as a capital gain.
The IRS audited the joint venture's tax return and challenged its capital gain. As the IRS viewed the facts, the entire structure resembled one real estate development. With a joint operation, all gains should be ordinary income. In effect, the IRS rejected a true distinction between the two business entities and ignored the multi-entity structure.
The joint venture sought relief with the United States Tax Court, but the Tax Court sided with the IRS and characterized all the gains as ordinary income. Under its view, the substance of the entire transaction produced ordinary income. None of the joint venture gains qualified as capital gains. The joint venture filed an appeal.
On appeal, the Fifth Circuit upheld capital gain and endorsed the land banking structure. The Appeals Court rejected the Tax Court's conclusion that the joint venture was a sham or an agent, and rejected the conclusion that the joint venture directly engaged in the business of selling land. The Fifth Circuit recognized a substantial business reason for having a corporation develop the land and sell it, namely the liability protection offered by a corporation.
The Fifth Circuit endorsed land banking by recognizing that the joint venture held the land as an investment and was therefore entitled to capital gains treatment on the gains realized by the sale. This favorable treatment saved significant tax liabilities. The case supports and recognizes tax savings earned by separating investment and developer activities through different entities.
A Separate IRS Attack: The Taxpayer Efforts Rule
In addition to disregarding the structure, the IRS may challenge land banking structures under the "taxpayer efforts rule." Under this theory, the IRS argues that property is held for development when a property owner's personal efforts create the increase in value of the property. Wealth created through personal efforts resembles compensation for services and is taxable at ordinary income rates. Even though the IRS likes this theory, the courts do not.
In U.S. v. Winthrop, the landowner subdivided and improved inherited property and, through such efforts, increased the value of the property. He reported the sales as capital gains. The IRS argued, "capital gains treatment is available only where the appreciation in value is the result of external market changes occurring over a period of time." The IRS claimed that the personal efforts increased value. But the Fifth Circuit rejected this theory, recognizing that many cases have accorded capital gains treatment "where taxpayer efforts have contributed to value . . . and the taxpayer's personal efforts are not the only factors to consider."
In another case, a small business corporation acquired a tract of undeveloped land and spent a significant amount of time and money preparing a subdivision application. The corporation also challenged new zoning requirements that would have rendered the plat useless. This challenge was lengthy, as it took four years to obtain plat approval. After the plat was approved, the corporation sold the subdivided property.
The IRS argued that since the corporation's personal land use efforts increased the value of the property, the property lost its status as a capital asset. But the court rejected this approach, holding that "[i]n an area of the tax law which is essentially factual, we cannot adhere to a blanket rule …" The corporation received capital gains.
Conclusion
Through a successful land banking structure, landowners can divide tax consequences between capital gains and ordinary income. Several cases, including an important 1992 case, support this technique, which minimizes ordinary income and maximizes capital gains taxed at favorable rates.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (1)avoiding penalties under the Internal Revenue Code or (2) promoting, marketing,or recommending to another party who is not the original addressee of this communication any transaction or matter addressed herein.
Jim Walker is RJ&L's senior tax partner. His practice focuses on providing clients with innovative tax advice. He also regularly represents taxpayers before federal and state administrative agencies, including the IRS, the Justice Department, and the Colorado Department of Revenue. He can be reached at 303-628-9510 or by e-mail at jwalker@rothgerber.com.