Consider Tax Strategy When Selling Real Estate
For those in the real estate industry, there are few dates as critical as the “placed-in-service” date, which drives depreciation calculations during any given year. Many assume this date should be used for determining long-term/short-term classification for sale calculations; however, especially in cases of a property sold shortly after construction is completed, this is not necessarily true.
It is key to understand the true holding period of the property as opposed to the placed-in-service date. Treasury regulations outline that the placed in-service date for a property is when it is “first placed in a condition or state of readiness and availability for a specifically assigned function.” The holding period, on the other hand, is based on the “acquisition date” of the property “regardless of whether the property was placed in service.”
For a taxpayer who constructs a building for use in its trade or business, the holding period begins progressively as the building is constructed. The taxpayer’s long-term basis for purposes of calculating gains from a sale is generally higher than it would be if only the “placed in service date” was to be utilized in the analysis. Revenue Ruling 75-524 notes that the “portion actually completed prior to [12] months before the date of sale is considered as held for more than [12] months for purposes of Section 1231 of the Code.”
Specific fact patterns and circumstances can change the applicability of the above and, therefore, it is important to consult your tax advisor regarding tax burden relating to the sale of properties to ensure regulations are being appropriately applied.
An Example Of The Payoff
Here’s an example of bifurcating holding periods in action.
- June 30, 2022 – Taxpayer purchases undeveloped land for $1.2 million, and begins construction shortly thereafter
- September 14, 2023 – Construction costs of $4 million are incurred through this date
- January 15, 2024 – An additional $800k of construction costs are incurred through this date
- February 1, 2024 – Certificates of occupancy are received, the buildings are officially “placed in service” and depreciation calculations can begin
- September 15, 2024 – The taxpayer closes on the sale of the property for $13 million, after being approached by an investor interested in the property. The land is assigned a value of $2.6 million, building the remaining $10.4 million
Gain on Sale of the Land
$2.6 million purchase price allocation – $1.2 million cost basis = $1.4 million gain.
This gain is treated as Section 1231 gain and taxed at 20 percent capital gains rates since the land was purchased more than two years before the sale.
Gain on Sale of the Building
$10.4 million purchase price allocation – $4.8 million cost basis (assuming depreciation wasn’t taken for simplicity of this example) = $5.6 million gain.
Applying the principles above, this gain would be bifurcated between short-term and long-term holding periods. For the costs incurred a year before the sale ($4 million), the holding period would be considered long-term, while the remainder ($800k) would be considered short-term, as it was not incurred/held more than 12 months before the sale. 83.33 percent of the gain on the building is treated as Section 1231 gain (eligible for capital gain rates) since that is the portion of the building basis with a long-term holding period ($4 million / total $4.8 million). This results in $4.67 million of the overall $5.6 million gain on the building being treated as Sec. 1231 gain eligible for capital gain tax rates, instead of ordinary income, which has a meaningful impact on the overall tax burden from the sale.
For taxpayers considering a sale of real estate property, the appeal of treating a larger portion of the sale as eligible Section 1231 gain is high and can be achieved with the proper information and analysis. Clear tracking of when costs are incurred can make the analysis process for these scenarios simpler, so taxpayers should keep well-documented cost reports through construction or redevelopment projects to achieve maximum benefit for investors and owners alike.
Contact a tax professional who specializes in real estate industry tax services to learn more or for assistance.
By Emma Giroux, CPA, tax manager
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