Using Land Banking to Preserve Capital Gains on Appreciated Land
[Ed note: “land banking” has been a popular planning idea since being blessed by the courts in Bramblett and Bradshaw. WS+B’s Eric Wilson, a budding real estate guru, stops by to explain the opportunity in full. Now, on to Eric:]
Investors who are considering developing appreciated land they have held longer than one year may benefit from a planning strategy known as “land banking”. The problem many investors face when subdividing or developing upon their land is that without careful planning, when each developed parcel is sold the entire gain on the sale is taxed at the ordinary income tax rate of 35%, including the appreciation attributable to the land. Here’s why:
If the appreciated land was not developed upon and was subsequently sold, the gain on that land would be taxed at the long-term capital gains rate of 15%. When an investor chooses to build upon and/or subdivide their land, they lose the benefit of capital gains treatment on the pre-development appreciation inherent in the land. This disparate result arises because upon beginning the development process, the owner of the land is effectively converted from investor to dealer, and the land is accordingly converted from investment property to inventory. Fortunately, this unfavorable tax treatment can be avoided through land banking.
Land banking is a tax planning strategy in which investors can achieve long-term capital gains treatment on the pre-development appreciation inherent in the land. The process begins with investors selling their appreciated land to an S-Corporation prior to beginning the subdivision or development process. This allows the investors to trigger the appreciation inherent in the land and recognize a long-term capital gain before the land is “recharacterized” as inventory by the development process.
The S-Corporation can be formed and owned by the investors for purposes of this transaction. The terms of the sale include the S-Corporation signing a promissory note agreeing to pay the investors in full once the land is fully subdivided, developed, and sold to buyers. This offers the added advantage of allowing the sellers to recognize their capital gain on the installment method. The S-Corporation should also pay a down payment and annual interest on the note at the applicable federal rate to the investors. Once the developed land is sold, the S-Corporation is obligated to pay the investors in full for the land, and the sellers will recognize any remaining capital gain previously deferred under the installment method. Any gain related to the development or appreciation on the land after the initial sale will be taxed as ordinary income. This transaction can result in substantial savings. Please consider the following fact pattern:
Ted and Jackie purchased land 10 years ago for $2,000,000 which has since appreciated to $4,500,000. Their basis in the land currently is $2,000,000 and if sold today would result in a long-term capital gain of $2,500,000. Ted and Jackie are interested in subdividing their land into townhouses and are left with two options. Their first option is to subdivide the land, build the townhouses, and sell them. Their second option is to sell the land to an S-Corporation, then subdivide the land, build the townhouses, and sell them. Although very similar, option two will result in substantial tax savings.
Assume to build the townhouses, Ted and Jackie had to incur $2,000,000 of construction costs increasing their basis to $4,000,000 ($2,000,000 land + 2,000,000 costs). In option one, if they sell all the townhouses for $10,000,000 they will realize ordinary income of $6,000,000 leaving a tax bill of $2,100,000 (assuming a tax rate of 35%).
In option two, when Ted and Jackie sell their land to an S-Corporation, they lock in long-term capital gains treatment on the pre-sale appreciation of the land and recognize a gain of $2,500,000, which is taxed at 15%, or $375,000. The S-Corporation receives the land with a stepped up basis of $4,500,000. The gain on the development of the townhouses of $3,500,000 ($10,000,000 selling price minus $4,500,000 cost of land to S-Corp minus $2,000,000 construction costs) is taxed at an ordinary income tax rate of 35%, or $1,225,000. This results in a total tax bill of $1,600,000. Compare that to option one’s tax bill of $2,100,000 – that’s a tax savings for Ted and Jackie of $500,000!
There are some important considerations that must be mentioned before engaging in land banking. The sale of land must be made to an S-Corporation in order to avoid adverse related party treatment associated with partnerships. Also, the sale of land to an S-Corporation must be made at “arms-length”. An “arms-length” transaction includes having a signed promissory note that bears interest, paying a down payment on the land, conveying the deed, and having a current appraisal on the land as valuation for the sales price. No land should be sold prior to it becoming property of the S-Corporation (i.e. completion of the promissory note). In addition, the investors must be able to convey an independent business purpose for organizing the S-Corporation and conveying the land to it (besides benefiting from capital gains treatment). An example of a valid business purpose is to limit the investor’s liability. Adherence to the above considerations greatly reduces the chance of an adverse ruling if the transaction is challenged by the tax courts.
There are many considerations that must be made before engaging in any strategy such as the one listed above. The above fact pattern assumes an arbitrage between long-term capital gain and ordinary income rates that may not always hold true, particularly in light of the impending election. However, both President Obama and Mitt Romney intend to preserve a substantial arbitrage between the top long-term capital gains and ordinary rates, meaning “land banking” should be a favored tax-planning tool for years to come.
