ONE STEP OVER THE LINE

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1 ONE STEP OVER THE LINE The Fuzzy Line Between Capital Gains and Ordinary Income Charles W. Trainor Trainor Fairbrook Sacramento, California If a client asks you in any but an extreme case whether, in your opinion, his sale will result in capital gain, your answer should probably be, "I don't know, and no one else in town can tell you." Byram v. U.S. (1983) 705 F.2d 1418

2 One Step Over the Line The Fuzzy Line Between Capital Gains and Ordinary Income By: Charles W. Trainor Trainor Fairbrook One of the most critical financial factors in real property ownership or development is structuring the ownership and sale to minimize taxes, thereby increasing return. The largest of those taxes is generally the Federal income tax payable upon any disposition of real property. 1 Many owners defer the payment of their Federal income taxes upon disposition by taking advantage of tax-deferred exchanges for like-kind property permitted by Section 1031 of the Internal Revenue Code. 2 For a variety of reasons, however, owners may elect not to exchange real property, and instead pay the Federal income taxes on any gain upon disposition. For those owners, it is important, to the extent possible, to obtain the most favorable tax treatment upon disposition, which is the payment of Federal income tax at the lower capital gains rate as an "investor," rather than at the higher ordinary income rate paid by "dealers." 3 The planning for favorable tax treatment upon sale begins prior to the purchase of the property when the ownership entity is established, and continues throughout ownership of the property and upon disposition. As indicated by the Byram case quote on the cover sheet of this paper, the Federal courts have long struggled with the factual analysis of who is an "investor" entitled to capital gains treatment and who is a "dealer," subject to ordinary income. One court has described the analysis of the difference between the two as an "indistinct line of demarcation between investment and dealership." 4 Analysis of any particular situation is "essentially a question of fact [citations omitted]. The totality of circumstances is of course controlling in each case. 5 1 This article will not attempt to take into account the effect of State income taxes because of the varying income tax policies amongst the States. 2 All section references hereafter, unless otherwise noted, are to the Internal Revenue Code. 3 An owner who experiences losses may prefer to report those losses as ordinary income rather than capital losses. The same principles and tests will apply in that analysis, but, for the sake of brevity, are addressed only tangentially herein. 4 Buono v. Commissioner 74 T.C. 187, at Brown v. Commissioner 448 F.2d 514, at , Charles W. Trainor One Step Over the Line Page 1

3 This article is intended to be a primer of the basic issues surrounding ordinary income (dealer) tax treatment vs. capital gains (investor) tax treatment for Federal income taxes upon the disposition of real property, and a survey of some of the factors that have been considered in making the factual determination. The article also includes recommendations for steps that attorneys can take in drafting documents and counseling their clients to help clients achieve favorable capital gains treatment. Other than passing references, it will not discuss tax-deferred exchanges or installment sales, which are other strategies for tax deferral only available to "investors." 1. The Basics. 1.1 Statutory Definition of an Investor and a Dealer. Any analysis of whether a taxpayer is an investor or a dealer begins with Section 1221, which defines a "capital asset." Section 1221 states, in the negative, that all property is a "capital asset" unless it falls into one of eight categories, three of which relate to real property. Those three exclusions are: (a) property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business; (b) property used in the taxpayer's trade or business; 6 and (c) accounts or notes receivable acquired from the sale of property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business. Most cases and controversies in this area revolve around the first exclusion, dealing with the question of whether the property is being held by the taxpayer as a "capital asset," or whether it is excluded from being a capital asset because it is being held by a "dealer" for sale to customers in the ordinary course of the dealer's trade or business. The term "dealer" does not appear in Section 1221, but is borrowed from the real property installment sale provisions that define a "dealer disposition" as the sale of real property "which is held by the taxpayer for sale to customers in the ordinary course of the taxpayer's trade or business." 7 The United States Supreme Court, in analyzing Section 1221 stated that: The purpose of the statutory provision with which we deal is to differentiate between the "profits and losses arising from the everyday operation of a business" on the one hand [citations 6 See Section Section 453(l)(1)(B) Note the absence of the word "primarily" in the installment sale provision. In Malat v. Riddell 383 U.S. 569, the Supreme Court stated that "primarily" means "of first importance" or "principally," not "substantially." One Step Over the Line Page 2

4 omitted] and "the realization of appreciation in value accrued over a substantial period of time" on the other [citations omitted]. A literal reading of the statute is consistent with this legislative purpose. 8 As shall be addressed in Section 2 hereof, the principal issue in any analysis of the characterization of gain or loss in the sale of real property is whether the taxpayer is a "dealer" or an "investor" under Section 1221, and whether the real property was being held as "inventory" or as an "investment." 1.2 Ordinary Income Rates vs. Capital Gains Rates. Since 1921, the Internal Revenue Code has provided for different tax treatment of the gains (and losses) for "capital assets" for certain taxpayers. The controversies between taxpayers and the IRS over whether property was an investment or held in a trade or business began almost immediately, and has continued unabated ever since. The rates and eligible taxpayers have changed many times since 1921, based upon economic conditions and political considerations. Since 2003, when the Jobs and Growth Tax Relief and Reconciliation Act of 2003 (2003 JGTRRA) was adopted, the longterm capital gains rate has been at 15 percent. 9 The 2003 JGTRRA also reduced the maximum ordinary income rate to its current level of 35 percent. 10 While the very favorable 15 percent rate was originally scheduled to expire in tax years ending before January 1, 2009, the Tax Increase Prevention and Reconciliation Act of 2005 extended the 15-percent rate for two more years, through tax years ending before January 1, Therefore, proper planning and documentation that will permit a qualifying taxpayer to obtain long-term capital gains treatment of its taxable gains will result in Federal income tax savings, in most cases, equal to 20 percent of the taxpayer's gain. As an example, an individual correctly holding and disposing of a property with $10,000,000 of gain as a capital transaction will result in a $2,000,000 reduction in the Federal income taxes paid in relation to the sale, thereby increasing the taxpayer's return on investment accordingly. 8 Malat, supra, at Section 1(h). In certain circumstances, the capital gains rate for certain depreciable realty can be 25 percent (See Sections 1(h)(1)(D) and 1250), which is not addressed in this article. Corporate taxpayers are entitled to capital gains treatment on the sale of property, also, but the rates for those transactions are not discussed in this article (See Sections 1201). Also, this Article does not address lower long-term capital gains rates for lowincome taxpayers. 10 Section 1(i). One Step Over the Line Page 3

5 1.3 Holding Period. Currently, in order for qualifying property to obtain long-term capital gains treatment, it must have been held by the taxpayer for one year. 11 The holding period has varied over the years, but, with minor exceptions has been generally been one year since Property held by the taxpayer for less than one year is still considered capital gain, 12 but as noted in Section 1.2 above, is considered to be short-term capital gain and is taxed at ordinary income rates. Numerous cases have interpreted the holding period, but the one-year period generally begins on the day after the property is acquired, and ends on the day that the property is sold. 13 The IRS and the courts have created special rules relating for certain types of property. For instance, a property classified as a capital asset on which construction has been undertaken by the taxpayer within one year of the date of its disposition will have costs that were incurred more than one year prior to the disposition allocated in the determination of long-term capital gains, and the costs incurred less than one year allocated in the determination of shortterm capital gains Entity-Level Taxation. One of the planning strategies used to avoid dealer characterization on disposition of property is to hold the property in a properly formed separate entity with an independent business purpose which has less of a likelihood of being deemed "in the business" by the tests created in the interpretation of Section Characterization is generally determined by analyzing the activities of the entity that owns the property, not on the activities of the individual members of that entity. For example, in pass-through entities like partnerships and limited liability companies, the determination of whether the taxpayer is a investor or a dealer will generally be determined by the activities of the partnership or the limited liability company, not the individual taxpayer. 16 The characterization of income for an S Corporation, by statute, is determined at the entity and not the shareholder level. 17 As a consequence, a dealer may qualify for capital gain if the entity which holds the asset is not engaging in dealer activities. 18 A dealer in real property may also hold real property for investment, but steps should be taken to carefully differentiate between the two types of properties Section 1222(3). 12 Section 1222(1); Section 1222(2). 13 See Fogel v. Commissioner, 203 F.2d 347 (5 th Cir. 1953). 14 See Revenue Ruling See Bramblett, infra; See Phelan, infra. 16 See Bayse v. Commissioner, 410 US 44; Podell v. Commissioner, 55 TC 429; Blackburn v. Phinney, 61-2 US Tax Cas Section 1366(b). 18 Blackburn, supra. 19 Fabiani v. Commissioner, T.C. Memo One Step Over the Line Page 4

6 2. Staying Behind the Line; Analyzing the Differences. 2.1 The Questions. As stated previously, the determination of whether the sale of property is the sale of a capital asset or the sale of property held primarily for sale to customers in the ordinary course of business is a factual one. The Supreme Court has ruled that the definition of a capital asset is to be construed narrowly. 20 In making the factual determination, three questions must be considered: (a) (b) (c) that business? 21 Was the taxpayer engaged in a trade or business, and, if so, what business? Was the taxpayer holding the property primarily for sale in that business? Were the sales contemplated by the taxpayer "ordinary" in the course of 2.2 Factors to Be Considered. In answering the three questions, different courts have listed a number of factors that should be considered, and have stated the same factors in different ways. The seven factors listed by the Bramblett Court, which generally encompass the important factors stated by various Circuit Courts and Tax Courts, are: of ownership; (a) (b) (c) (d) (e) the nature and purpose of the acquisition of the property and the duration the extent and nature of the taxpayer's efforts to sell the property; the number, extent, continuity and substantiality of the sales; the extent of subdividing, developing, and advertising to increase sales; the use of a business office for the sale of the property; (f) the character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and (g) the time and effort the taxpayer habitually devoted to the sales. 22 The Court in Maddux Construction v. Commissioner, 23 added two additional factors: the "purpose for which the property was subsequently held," and the "purpose for which the property was being held at the time of sale," because the intent of the taxpayer may change during its period of ownership or at the time of sale. 20 Corn Products v. Commissioner, 350 U.S. 46, at Suburban Realty vs. U.S., 615 F.2d 171, at 178; Bramblett v. Commissioner, 960 F.2d 526, at Bramblett, supra, at TC 1278, at One Step Over the Line Page 5

7 Of all the factors to be considered, the courts have consistently ruled that the frequency and substantiality of sales is the most important factor to be considered Case Law Examples of the Factors. There are dozens of cases interpreting and analyzing the foregoing factors, a review of which provides no consistent pattern of analysis or result. Each case is based upon its own facts, and the weight the court gives those facts when applying each of the factors. The following section constitutes a survey of several cases which have applied the foregoing factors, as well as certain additional evidentiary items that may be considered by the Internal Revenue Service and the courts Number, Frequency, Continuity and Substantiality of Sales. (a) Number, Frequency and Continuity of Sales. If the taxpayer's land sales are frequent, continuous and large in number rather than isolated this activity indicates that the taxpayer is a "dealer." An investor is less likely to frequently buy and sell land, or to do so continuously. 25 A taxpayer who made 244 sales over a 32-year period was a dealer. 26 A taxpayer who sold 208 lots in 12 individual parcels from a subdivision over a 31-year period was a dealer. 27 A taxpayer who sold 456 lots over a 19-year period was a dealer. 28 (b) Substantiality of Sales. Substantiality (or size) of sales is a factor that has been considered by the Ninth Circuit since the Stockton Harbor case, and is essentially another way of stating the frequency of the sales as noted in the first factor above Purpose for Acquisition and Reason for Which Property is Held. Many cases indicate the courts will look to the taxpayer's intent at the time the taxpayer acquired the property. Intent at the beginning of the investment or at the time of sale is not determinative, and, in either event, is simply one of the factors that courts will consider. 30 In Continental Can Co. v. U.S., 31 the Court found that a taxpayer, who had held property as a capital asset for many years, changed the character of the property when it began selling all of the property that it owned. 24 Suburban Realty, supra, at 178; Biedenharn v. Commissioner, 526 F.2d 409, at Pool v. Commissioner, 251 F.2d 233, at 237; See also Stockton Harbor Industrial Co. v. C.I.R, 216 F.2d 638, at Suburban Realty, supra. 27 Biedenharn, supra. 28 U.S. v. Winthrop, 417 F.2d Stockton Harbor, supra, at Pool, supra, at F.2d 405 One Step Over the Line Page 6

8 2.3.3 Development Activities. This factor includes activities such as subdividing and/or improving the property, including construction of roads, sewer lines and houses Sales Activities. The extent and type of sales activities is often considered by the courts. For instance, whether or not the taxpayer has a real estate license or has engaged a real estate broker to advertise and sell the property will be considered. Many cases even mention the presence or absence of a "for sale" sign on the property Duration of Ownership. Although not explicitly mentioned as a factor in Bramblett or Maddux, in Palos Verdes, the Tax Court stated that "it is sound law that holding an asset for many years indicates an intention to hold for investment, rather than for sale." 34 In the Palos Verdes case, the taxpayer held the property for over 20 years and was still considered a dealer when he had to sell it in numerous parcels in order to dispose of it. In another case, the property was held for between two and six years and the owner was considered an investor Relationship of Property to Business. The proportion of the taxpayer's income that results from the sale of land is used by the courts as an indication of dealer status. The higher the proportion, the stronger the inference Maintaining Sales Office and Real Estate Licenses. This factor is closely related to sales activities and tends to indicate an ongoing business operation in the sale of land Taxpayer's Statements. Often the taxpayer's own statements, made either in court or on previous tax returns, are considered, and they indicate whether or not the taxpayer considered itself to be a dealer in land Replacement Property. If the owner is contemporaneously, or soon before or after, buying or selling other properties on his own account as a dealer, the courts have used this evidence to deny capital gain benefits Stockton Harbor, supra, at Palos Verdes Corp. v. U.S., 201 F.2d Supra, at Austin v. Commissioner, 263 F.2d Stockton Harbor, supra, at Hansche v. Commissioner, 457 F.2d Stockton Harbor, supra, at Pacific Homes v. U.S., 230 F.2d 755, at 760. One Step Over the Line Page 7

9 Catch-All Category. The Ninth Circuit stated in Pool, that "any other factor reasonably tending to show that the transaction was in furtherance of or in the course of the taxpayer's occupation or business," may be considered Strategies to Avoid Dealer Status and Ordinary Income. 3.1 The Related-Party Transfer - Bramblett and Phelan. One of the successful strategies used by land developers to maximize capital gains treatment is to initially purchase the property in an investment entity, such as a partnership or limited liability company. While the property is being held for "investment" in that entity, the developer undertakes steps to prepare the property for development, such as obtaining environmental approvals and entitlements, without dividing the land or making any improvements to it. In this manner, the taxpayer can legitimately say that it was holding the property for investment and not taking any steps to be "in the business" of selling real estate. At the appropriate time, after the one-year holding period has been met, the investment entity then sells the land to a related corporation for its fair market value, usually with seller financing. Obviously, if a parcel of investment land which does not have development entitlements successfully obtains development entitlements during the holding period, the land will have increased considerably in value. Upon transfer of the property to the corporation for development, that gain is reportable as capital gain to the investment partnership. Any subsequent gain realized by the corporation would be from developing the property and holding it for sale, hence ordinary income The Decision in Bramblett. In 1992, the Fifth Circuit, in the case of Bramblett v. Commissioner, 41 reviewed this foregoing factual scenario and agreed that the investment entity taxpayer was entitled to capital gain treatment despite some potentially negative factors. The taxpayer in Bramblett was a partnership, Mesquite East Joint Venture, which was owned by four individuals. Within one month after formation of the partnership, the same individuals, in the same ownership interests, formed Town East Development Company, a Texas corporation. In 1979 and 1980, the partnership acquired several parcels of land for "investment." The partnership then, over a series of four years, sold the parcels that it had acquired to the corporation, which, at the time of each sale, had already entered into agreements to sell the property to third parties. The first four sales, over a three-year period, resulted in a profit of only $68,000. However, the purchase price for the fifth and final sale was for 40 Pool, supra, at Bramblett, supra. One Step Over the Line Page 8

10 $9,830,000, which sale the IRS deemed to be a sale of business inventory subject to ordinary income. The Bramblett Court looked carefully at each of the factors set forth in Section 2.2 above in rendering its decision. The Court concluded that the partnership's transfer of five parcels over a four-year period of time did not "rise to the level necessary to reach the conclusion that the taxpayer held the property for sale rather than for investment." 42 The Court went on to determine that the investment partnership had held the property in question for over three years, did not advertise or hire brokers, did not develop the property and did not maintain an office. It further determined that the partners did not spend more than a minimal amount of time on the activities of the investment partnership. The Internal Revenue Service also alleged, since the ownership of the partnership and corporation were identical, that the Court should look to the "well-known principle of substance over form." 43 However, the Court determined that the reason for establishing the corporation was to "insulate the partnership and the partners from unlimited liability from a multitude of sources, 44 and determined that there was no substantial evidence that the transaction was not an arm's length transaction or that proper business and legal formalities were not observed. In short, the Court felt that there was a legitimate purpose for the transfer. This conclusion was reached despite the fact that the property was sold by the partnership to the corporation in return for two promissory notes (100 percent financing) which provided for interest at 12 percent per annum with annual payments of $1,500, No interest was ever paid on the notes, nor were any installment payments ever made on the notes by the corporation. Also, the principal payments to the partnership on the notes were only made when the properties were sold by the corporation The Decision in Phelan. The decision in Bramblett was challenged and affirmed in the case of Phelan v. Commissioner. 45 In Phelan, the taxpayer was a limited liability company rather than a partnership, as in Bramblett. The Internal Revenue Service argued that the "business purpose" had not been fulfilled, as it was in Bramblett, because the taxpayer already had liability protection within the limited liability company. Because the sale in question involved only one portion of the taxpayer's land, though, the Phelan Court ruled that a valid business purpose existed in transferring that portion of the land slated for development to the corporation in order to insulate the remaining land owned by the taxpayer from liabilities associated with development. 42 Bramblett, supra at Bramblett, supra at Bramblett, supra at Phelan v. Commissioner, T.C. Memo One Step Over the Line Page 9

11 3.1.3 Related-Party Considerations. Structuring any transaction to related parties should take into account the following matters: (a) Each of the factors set forth in Section 2.2 hereof must be carefully evaluated and followed by the investment entity. (b) There must be a legitimate business purpose for creating the corporation and transferring the property to the corporation. As stated above, the most frequent reason, and the purpose of utilizing a corporation rather than another partnership, for instance, is usually liability protection or additional liability protection. (c) The transaction must be an arm's length transaction between the two entities, and the sales price should be at fair market value. In order to prove that fact, obtaining an appraisal is highly recommended. (d) All business and legal formalities of a sale between two distinct entities should be observed. In addition, in order to show the legitimacy of the development corporation, it is advised that the development corporation be properly capitalized. One cautionary note in related-party transactions is that, since most sales will be on an installment-sale basis, 46 the installment-sale rules will be applicable. As a sale of investment property, the investment entity's gain should receive long-term capital gain. However, because the sale is being made to a related party, the seller may not defer the gain if the related party re-sells the property within two years. That is normally not an issue, however, because the note to the investment entity is usually paid in full at the time the property is sold by the development corporation. As a final caution in this area, it should be noted that the Commissioner did not appeal the Fifth Circuit Bramblett decision to the United States Supreme Court, and many speculate that it was because of a concern that it would be upheld and become the law nationwide. The Commissioner also did not appeal the Phelan decision from the Tax Court. As a consequence, the law could be different in varying Circuits and consideration should be given to the venue of the taxpayer. 3.2 The Long-Term Land Hold - Section 1237 Safe Harbor. Section 1237 provides a "safe harbor" from the characterization of profit as ordinary income under limited circumstances involving the sale of unimproved land which has been held by the taxpayer for at least five years. The Section permits qualifying owners to subdivide property into multiple 46 Section 453. One Step Over the Line Page 10

12 parcels in order to sell them without having to pay ordinary income tax. The section also allows the taxpayer to perform limited improvements to "enhance the value" of the property before sale. Without Section 1237, dividing land into multiple parcels for sale would be a "development activity," which could recharacterize the property as being held in a "trade or business" for the sale of real estate, rather than as an "investment." The following questions must be considered in order to qualify for Section 1237 treatment on unimproved land: (a) Is the parcel a single tract of land? Multiple parcels are considered to be a single parcel if their boundaries meet at any point, or if they are separated only by a road, railroad, stream, etc. 47 Parcels purchased previously at different times from varying owners may be combined. (b) Has each taxpayer held its tract of land for at least five years or was it acquired by inheritance during that five years? 48 (c) Do any of the taxpayers hold any other real property for sale to customers in the "ordinary course of the taxpayer's trade or business?" The taxpayer may not have another dealer property for sale in the same tax year. 49 In other words, is any taxpayer dealing in real property sales to the extent that the taxpayer would be classified as a "dealer?" (d) It is a consideration whether any of the owners hold a real estate broker's license. If so, is that license used license for the sale of real estate? However, the possession of a license will not necessarily exclude this sale from the Section 1237 safe-harbor rule. (e) Has the taxpayer substantially improved the property in a manner that enhances its value, such as installing hard surface roads or installing utility systems (such as gas and electric lines or water and sewer lines)? Improvements may be insubstantial or "necessary improvements" if the property has been held for ten years and (i) the improvements were water, sewer, drainage and roads, (ii) the improvements were necessary to sell the lot at the prevailing local price for similar lots or (iii) the taxpayer elects not to deduct the improvement costs or basis in the lot. 50 As a general rule, if the improvements increase the value by ten percent or less, they are insubstantial and do not disqualify the property from Section 1237 treatment. 47 Section 1237(c); Regs. Section (g)(2). 48 Section 1237(a)(3); Regs. Section (a)(5), (d). 49 Section 1237(a)(1); Regs. Section (a)(5), (b)(1)(ii). 50 Regs. Section (c)(3). One Step Over the Line Page 11

13 (f) Is the property held in a corporation? C Corporations or Subchapter S Corporations are not eligible for Section 1237 treatment. Holding the property in a partnership is acceptable. 51 If the taxpayer meets all of the Section 1237 criteria, the taxpayer will be entitled to the Section 1237 "safe-harbor" protections, so long as the taxpayer does not do anything else to create a trade or business in real estate with the property. The evaluation of whether Section 1237 applies will, of course, occur as of the time that the property is sold, so taxpayers wanting to rely on Section 1237 must keep in mind the Section 1237 criteria as they continue ownership or remain in contract to sell their property. Section 1237 does not provide complete insulation from ordinary income treatment. The Section says that the taxpayer will receive capital gain treatment on the first five sales, and thereafter gain will be ordinary income to the extent of five percent of the sales price. 3.3 Other Strategies to "Stay Behind the Line." In order to assist the taxpayer who wants to have the disposition of its real property classified as a capital asset, the following strategies will be of assistance: Name of Entity. Do not use the word "Developer" in the name of the investment entity. To do so will indicate that the entity is a dealer, even if its activities are not State the Business Purpose as "Investment." In formation of the taxpayer entity, if the taxpayer wants it classified as an "investor," clearly state that the business purpose of the entity is "to acquire and hold real property for long-term investment." In any purchase agreement, wherein real property is being purchased, include a statement that the "property is being acquired for long-term investment." In any sales agreement to sell the property, state that the property has been "held for investment." If the property is being transferred to a related entity, make sure that the purchase or option agreement states the legitimate business purpose or purposes that are precipitating the transfer Avoid Other Reference to Dealer-Type Activities. Even though the business purpose might be stated incorrectly in a document, other parts of the document can be revealing as to the taxpayer's intent. As an example, provisions contained in capital contribution provisions suggesting that contributions will be made for "construction" or "development" could show dealer intent. Also, references to "construction loans," "infrastructure," "final maps," or other developer-type activities will show an intent and be weighed against a taxpayer trying to obtain capital gain treatment. 51 Section 1237(a); Regs. Section (a)(1). One Step Over the Line Page 12

14 3.3.4 Statements, Correspondence and Government Documents. Oral statements regarding the taxpayer's intent to develop the property, letters to third parties, and government applications (e.g., for a building permit), all provide evidence to the government about the taxpayer's intent, and can be used to create the taxpayer's "intent" to make a "capital asset" into a "dealer asset" during the period of ownership Tax Forms. The first document filed with the Internal Revenue Service upon formation of an entity is the Application for Employer Identification Number (SS-4), which requires the party completing it to "Check one box that best describes the principal activity of your business," and "investment" is not a choice. To properly complete the document for an investment entity, the box labeled "Other" should be checked, and "Real Estate Investment" should be inserted thereafter. Likewise, on tax returns filed with the Internal Revenue Service, the forms will ask the "Principal Business Activity" and the "Principal Product or Service" (See IRS Form 1065, U.S. Return of Partnership Income, Questions A and B). Such questions should always be answered as "Investment" for an entity seeking to be classified as an investor. Finally, when completing the balance sheet of the business on the tax forms (Schedule L to the Form 1065); capital assets should be listed as "investments." Balance Sheet and Other Business Records of the Business. The balance sheet and other records of the business should refer to capital assets as "investments," and not other types of properties Follow the Factors. As demonstrated in the numerous cases cited herein, many of the factors that will make the difference between a disposition being taxed as a capital asset or a dealer asset will be the conduct of the taxpayer during the period of ownership (development of the property, maintaining an office, maintaining a broker's license, spending significant amounts of time on the business, etc.) 52 and the conduct of the taxpayer at the time of disposition (the number and substantiality of sales, advertising, listing with a broker). Keeping those factors in mind and avoiding the "dealer" activities to the greatest extent possible will provide the some assurance that gain will be considered to be a capital gain. 4. Condominium Conversions. Although taxation of condominium conversions is beyond the scope of this paper, the Bramblett/Phelan means of creating the maximum amount of capital gains treatment in a land development is not applicable in the development of depreciable real property, such as the conversion of an apartment building into condominiums, because of Section The process 52 "A simon-pure investor forty years ago could by his subsequent activities become a seller in the ordinary course of business." Biedenharn, supra, at 423. One Step Over the Line Page 13

15 of converting an apartment project into condominiums involves all of the activities that make a taxpayer a "dealer," such as the creation of a subdivision, construction and marketing, with multiple and continuous sales. Therefore, despite the "investment" intent of the owner upon the purchase of the apartment building, and no matter how long the owner has held it, the activities of the owner in creating condominiums will definitely change the purpose of the holding and make the owner a dealer. So, like in land development, the taxpayer will want to engage techniques that will allow the transfer of the apartment building before conversion in order to obtain the maximum capital gains treatment before the property is converted to a "dealer" property, which is held as inventory. Section 1239 provides for different treatment of depreciable real property, 53 such as an apartment building, as opposed to non-depreciable real property, such as land. Section 1239(a) treats any gain recognized on the sale or exchange of property between related persons as ordinary income, not capital gains. "Related persons," as defined in section 1239(b) for purposes of this discussion, is a person and all entities which are "controlled" entities with respect to such a person." The term "controlled entity" is defined in section 1239(c) as (a) a corporation more than 50% of the value of the outstanding stock of which is owned (directly or indirectly) by or for such person, (b) a partnership more than 50% of the capital interest or profits interest in which is owned (directly or indirectly) by or for such person, and (c) an entity which is a related person under constructive stock ownership rules of section 257(c). As a consequence of Section 1239, any taxpayer changing the character of its depreciable property from an investment property to a dealer property must employ different techniques than Bramblett/Phelan to avoid the recharacterization of the gain resulting from the condominium sales. 5. Conclusion. For 85 years, the differences between capital assets and dealer assets have been decided on a factual basis, weighing the factors determined by the courts, and applying them to the facts. Unfortunately, no end is in sight. The IRS will always be looking to make gains ordinary income, and losses capital losses. The only refuge may be a private letter ruling before the sale. 53 Section 167 One Step Over the Line Page 14

16 So, in conclusion, if a client asks you whether capital gains treatment will be afforded upon the sale of real property, tell the client that you have it on very good authority that "I don't know, and no one else in town can tell you either." One Step Over the Line Page 15