Tax Avoidance Strategy
I'm looking to develop some industrial condos. That means I will build them and sell them ASAP, so my holding period will be short, less than a year. (hopefully!) The problem is that my gains on the project will be taxed at ordinary income rates, close to 40%. How can I avoid that?
A 1031 exchange won't work with this type of situation, I'm told. But how about this idea: I lease the property to the potential buyer for a year, after which he has the *option* to buy it from me. He doesn't HAVE to buy it, and frankly, I'm just as happy to have him keep leasing for the next 20 years or more. (I'm really not hung up on making condos out of this project, if I can lease it up and not sell any units, I'm comfortable with that. OR, if I don't lease any long-term, and wind up selling all of them, that's fine too.)
So, in the above scenario, if after a year the lessor exercises his option and buys the unit, it should count as a long-term capital gain, right? That would be taxable at about 20% (state & federal).
Is there anything wrong with this concept?
CharlieT
Hi Charlie,
Your proposed scenario should work because you have the intent to HOLD the property as investment/rental property by leasing the property to the tenant and the tenant does NOT have to acquire the property from you. Once the tenant exercises the right or option to acquire the property you would be able to structure the transaction as a 1031 exchange.
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Bill Exeter
[ Edited by JohnLocke on Date 06/19/2004 ]
I can not tell if you need to sell any or not? It seems that pulling the cash out is not an immediate requirement.
Are you saying that most users would prefer to purchase? Many businesses I know would rather have a long term lease then a purchase as there is less capital tied up in the deal and easier credit qualifications. Is the motivation to sell driven by your needs or are you implying that many of the people who want the space want more then a lease?
You made no mention of your credit assumptions and if you can finance the property after it is developed. If so then a long-term lease (with or without an option to purchase) becomes possible. I would also expect that any entity that wants to lease long term may be just as happy with an option to extend the lease vs. an option to actually purchase the space.
Depending on the business and its credit situation owning property might be a really bad use of capital. If the business is a smaller entity the business owner might want to buy the place through a pension or in their own name. That is another angle.
John
[addsig]
It appears to me that developing and selling these condos is a dealer activity. Even though you said you will ":sell" on lease-option, I believe your transaction will still be a dealer activity (no intent to hold for long term rental income).
As a dealer activity, your profit is taxed as ordinary income regardless of your holding period. A dealer activity is also an active business income activity which brings 15.3% self-employment income taxes into play, too.
Charlie,
My guess is that when you file the condo declarations the transaction becomes a dealer transaction. You are buying at wholesale and selling at retail. Whenever you actually recognize the income (i.e. when they exercise the option under the L/O) its still going to be a dealer transaction.
You might be able to avoid the taxes by doing the deal inside a self-directed IRA which then wouldn't have to pay the income tax until you took the money out. You could then use the IRA as a development entity to do more projects.
When you remove money from the IRA prematurely you pay a 10% penalty plus your normal tax rate. Still cheaper than a dealer status because you only pay taxes on the part you take out to use on non-realestate stuff. The investment deals stay in the IRA.
Thanks for all the input, folks. I don't really want to do this inside an IRA, although I appreciate the suggestion, because I would like to have access to the cash generated by either a condo sale or the lease income.
I understand the concern about being declared a dealer, but if I hold the units for at least a year, and can't force the tenant to buy the unit, doesn't that preclude my being a dealer? After all, I have no control over whether he exercises the option, and I am happy to have him lease forever. And, he has the right to lease forever, and I'm sure some tenants will do that. (Well maybe not forever, but you know what I mean.)
I bet there's a precedent for this kind of thing, probably many times over. I'm sure this isn't even remotely close to the first time it's been suggested. Anyone know of any previous IRS rulings on the subject?
CT
If you want, think about the IRA lending the developing company then $$, then when they sell and you pay off the note, you do get the liquid profit.
The dealer thing seems to be a sticky issue. I just spoke to me CPA about it, and things still are 100% clear and appear to be subejct to interpretation.
Does anyone have a link that states a 1031 is only available if the intent it to hold the property? My CPA and title company (that performs 1031) both say that intent has nothing to do with the qualifying of a 1031.
Brenda
have you checked out http://www4.law.cornell.edu/uscode/26/1031.html ?