During the recent residential housing boom, many apartment building owners converted their rental units to condominiums. Though the market has cooled a bit over the last year and a half, interest in condo conversions remains strong. But with the current downward pressure on prices and the increased expectation of seller assistance with closing costs, property owners need to reexamine the potential income tax cost associated with these conversions.
Structuring a condo conversion properly can yield capital gains instead of ordinary income, subjecting earnings to the 15 percent federal capital gains tax rate as opposed to the 35 percent top ordinary tax rate. When successful, these savings can restore much of the financial luster that has been lost due to softening market conditions.
However, capital gains treatment is available as an option only in those instances where individuals own a property either directly or indirectly via a pass-through entity (i.e., partnership, limited liability company [LLC], or S corporation). It also is important to note from the outset, especially with apartments, that the portion of the capital gain attributable to the depreciation taken is subject to a 25 percent tax rate.
Avoiding dealer status is generally the key to achieving capital gains treatment for the sale of property. Section 1221 of the Internal Revenue Code disallows capital gains treatment for the sale of property held by a taxpayer primarily for sale to customers in the ordinary course of business. Whether property is being held for sale in the ordinary course of business is very dependent on facts and circumstances. Over the years, published Internal Revenue Service (IRS) rulings and decisions rendered by the courts have developed several factors used to make this determination.
They are as follows:
- the frequency, number, and substantiality of sales;
- the taxpayer’s intent or purpose for the purchase of the property;
- sales and marketing activities undertaken by the taxpayer either directly or through the use of brokers or agents; and
- the extent of subdividing and de-veloping the property to increase its value.
As with any planning technique driven by facts and circumstances, there are favorable as well as unfavorable rulings to consider, but the orderly liquidation approach receives support from some very favorable case law. The approach relies on the owner’s ability to show that the conversion to condominiums and the sale of the units can be classified as the orderly liquidation of trade or business assets (i.e., rental property) and not a change of status to being in the trade or business of selling condominiums.
The Goldberg v. the United States case from the 1950s was one of the first to explore this theory. During World War II, rental units were built to provide housing for defense workers.
After the war, the rental market dropped off and housing sales boomed with the return of the troops. Due to this significant change in market conditions, the property owner decided that it would be better to sell off its rental portfolio and, in 1946, 90 houses were sold.
In fact, demand was so strong that no sales or marketing activities were undertaken, the houses were sold by word of mouth, and there were no real estate commissions paid. The court agreed with the taxpayer that the sales were not a result of changing the nature of their business from rental to sales, but a strategy to exit from the business of rental real estate in light of changing market conditions.
A case that dealt directly with apartments being converted to condominiums is the 1987 Gangi case. In Gangi, two individuals formed a partnership and constructed a 36-unit apartment building as part of their retirement planning. After eight years of renting, the business relationship between the partners had soured and the two decided to part ways. An analysis of the property showed that the value could be maximized by selling condo units versus selling the building intact. The partnership went through the conversion process, listed the units, and sold 26 of them within one year.
The IRS argued that the conversion had changed the intent from investment and rental to holding property for sale in the ordinary course of business. The court, however, held that the taxpayers had merely liquidated their investment, a business decision based on market conditions and a desire to part ways. The conversion was just a step taken to effect the liquidation.
What these cases and others show is that it is possible to have a high number of sales and not necessarily be viewed as having sales in the ordinary course of business. As with any fact-based argument, extreme care must be taken to apply these cases to a different situation.
Another avenue to explore that may yield the desired result of capital gains treatment is to sell the apartment building to another entity prior to converting it to condos. A sale at market value will trigger the gain in the entity that held the property for rental purposes, and that gain will be subject to capital gains rates. This technique has been used successfully in connection with raw land in both the Richard H. and Patsy J. Bramblett v. Commissioner and Timothy J. and Deborah A. Phelan v. Commissioner cases. The key to this strategy is that there must be a business reason, aside from tax planning, behind the sale. Two of the most common reasons would be the de-sire to limit liability exposure and the involvement of different partners in the sales activity.
In addition to the normal issues faced whenever contemplating a sale to another entity, such as arm’s-length dealing, avoiding agency relationships, and establishing a business purpose, the sale of an apartment building to an entity that will convert it to condos and market them for sale has one additional hurdle—Section 1239 of the Internal Revenue Code. Section 1239 recharacterizes what would normally be capital gains into ordinary income when a related party acquires depreciable property. However, there are two possible ways to deal with this rule.
The first is to plan to avoid the related party designation. In this case, if more than 50 percent of the ownership of the two entities is under common control, then they are considered related.
Ownership by various family members will be attributed to each family member. For example, if a father owns 40 percent and his son owns 20 percent, they are each deemed to own 60 percent.
This keeps owners from spreading ownership across various family members to avoid the related party rules. Therefore, 50 percent of the entity buying the apartment building must be unrelated to the existing ownership.
At first glance, it would appear that this hurdle would be insurmountable. Why give away 50 percent of the profit to a new partner in order to get a better tax rate? Though a new 50 percent partner would have to be found to participate in the condo sales entity, that new partner would not be getting 50 percent of the overall profits. Most of the profit would be triggered in the existing entity that owns the property. In selling the building to the condominium sales entity, the price would normally capture most of the profit back in the rental entity.
In addition to how the pricing is set, another way to deal with the related party rules is to look more closely at who is considered related. Some family relations (e.g., stepparents and in-laws) fall outside the rule’s definition, so it may be possible to keep the ownership within the expanded family and not trigger the related party rules.
Another way to deal with Section 1239 is to look at whether the property fits the definition of depreciable property. A literal interpretation of Section 1239 implies that the property is depreciable in the hands of the acquirer. Since the entity acquiring the property intends to convert it to condo units and sell them, it can be argued that the acquiring entity is a dealer with respect to the condominiums. Therefore, the condos are dealer property and are not depreciable.
With this last approach, it is very important to be very clear that the acquiring entity is a property dealer. By choosing this approach, the related party rules under 1239 are rendered moot, making it possible to use identical or nearly identical ownership to the selling entity. While this strategy is consistent with the wording of Section 1239, there is no case law at present to either support or deny this position.
A conversion from apartments to condominiums does not automatically taint what would have been a capital gain and convert it to ordinary income, but preserving capital gains status cannot be assumed. Several avenues do exist that can be employed to structure your conversion either to preserve capital gains treatment or to claim most of the profits as capital gains. Each approach has its own strengths and pitfalls, so proper planning with a certified public accountant is essential in order to maximize the potential tax savings.
W. Michael Howlett is a tax partner with Cherry, Bekaert & Holland, LLP, and a member of the firm’s Real Estate and Construction Industry Group. He is licensed as a certified public accountant in Virginia.
