Note #16: Once a Real Estate Developer, Not always a Real Estate Developer . . . . Complicated Tax Planning

Some of my best friends are developers.

Well, not really, but not because I don’t like developers.  We lead a quiet life and don’t socialize much, and don’t really run with the developer crowd.

But some of my best clients have been developers.

In many cases, the basic underlying facts are more or less the same.  The basic  underlying and important tax rules are almost always the same.

The developer calls about a piece of land.  At one time, the developer had planned to develop the property, but at some point along the way those plans changed, or, at least, the developer began to explore other options, including, if the numbers could work right, various conservation donation options.  The property might be fully permitted, but the market shifted.   Or the property might have been held for a while with high hopes for significant development, or just a sale for a profit, but something changed.  There is a whole range of fact patterns, from just holding the land and waiting, at one end of the spectrum, and a full-scale development plan at the other end of the spectrum.  We can call these the usual cases.  (For a slightly different situation, where the facts start off a lot better but many of the same tax issues are still lurking in the background, see “On The Other Hand,” below.)

This Note #16 is about one of the usual cases.

The developer wanted to make a very important gift of land (and, in the end, after doing some planning, the developer did in fact make the gift).  Initially, I spoke a few times with an advisor to the client and we discussed the legal strategy.  He then requested I put my recommendations in a memo.  Most of what follows in this Note #16 is taken from the memo I prepared.

 

Legal Analysis

Background.   Assume Mr. Wentworth owns Greenacres, and has been actively pursuing development of Greenacres for years.  Assume Mr. Wentworth is now prepared to donate Greenacres to a government agency or charitable organization.  There are tax issues.

The following paragraph includes major simplifications of some very complicated income tax rules.

As a general rule, when a company (or individual) donates to charity a “product” that it otherwise manufactures and sells to customers (let’s call that product “inventory”), the donor is entitled to an income tax deduction for the charitable gift but the deduction is generally limited to the cost or basis of the product, rather than its full fair market value.

For example, if an auto manufacturer donates cars to a local charity event, those cars are inventory and the deduction is limited to the manufacturer’s cost or basis.  Similarly, when a real estate developer donates house lots (that is, land held in inventory, for sale to customers) to a charitable conservation group or to the town, the deduction is generally limited to cost or basis.  Based on the facts of our case, we can assume Mr. Wentworth is a real estate developer with respect to Greenacres.   Keep in mind that for purposes of this determination, the “occupation” of the landowner is not the issue (though it can be one of the issues).  The important issue is whether a particular piece of real estate is held for sale to customers in the ordinary course of business.  In the tax cases, a developer who holds inventory property for sale to customers is often referred to as a “dealer” in real estate.

(In Note #5, I discussed certain rules in the tax code that make it more difficult for real estate developers to get a meaningful income tax deduction for charitable contributions of real estate, and the basis limitation for inventory donations is one of the most important obstacles.  See that Note for a longer discussion.)

Here is another relevant rule (again, very simplified):  if you own property for one year or less, and you donate that property to charity, your deduction is limited to cost or basis. This rule is generally referred to as the “holding period” rule.  (Note that the holding period rule and the inventory-donation rule both have the same result:  the deduction is limited to cost or basis, although the rules are completely separate from one another.)  If you own property that is not inventory for more than one year and you donate that property to charity, your deduction is (generally) equal to the fair market value of that property.  Solely for purposes of this Note #16, let’s call that property that is not inventory a capital asset.

So to start with, in most (but not all) cases, if a real estate developer owns land and has been moving through the development process with that land, filing applications, filing plans, seeking regulatory approvals, that land is treated as inventory.  In some cases, for technical tax and planning reasons, that land is not treated as inventory, but this Note is about the real estate developer who shows up with inventory property and is contemplating some kind of charitable contribution:  an outright gift of the land, a gift of a conservation easement, or a bargain sale (see Note #2) of the land or of an easement.  (And the tax issues I discuss in this Note are generally the same, regardless of whether the gift is an outright gift of land, or a conservation easement, or a bargain sale of either land or a conservation easement, but see “It’s Really More Complicated Than That,” at the end of this Note.)

 

The Owner Can Change His Mind

The case law is indisputable that property once classified as inventory can, under various circumstances, be classified as a capital asset.  Or, put another way, there are a number of cases that say absolutely yes, a developer can change his mind.  There are much longer legal treatises on this point.  See the case of Biedermann v. Commissioner, 68 T.C. 1 (1977), previously sent to you.

I believe the following cases also support this point.  (There are also a number of cases holding that land once held for investment can be turned into inventory, but I have not included any citations to those.)

• Land purchased for development; abandonment of intention; capital gain on sale. Loans and Service, Inc., DC Ohio, 61-1 USTC Par. 9536, 193 F. Supp. 683.
• After abandonment of prior plans, liquidation of land resulted in capital gain. Washington Realty Co. and Oak Hill Realty Co., DC Tenn., 62-2 USTC Par. 9748.
• Capital gain when property sold after certain permits were not received. A. Scheuber, T.C. Memo 1961-43.
• Builder acquired land to subdivide, plans to do so abandoned, thereafter held property as an investment, sale (some two years later) entitled to capital gain treatment. Maddux Construction Co.,  54 T.C. 1278.
• Property acquired for development by developer turned out to be unsatisfactory for same, found to be held for investment at time of sale. K. Dean Est., T.C. Memo 1975-137.
• Developer acquired land for subdivision, intent to subdivide frustrated by city, when land was sold to city it was no longer inventory. M. Knudsen Est., T.C. Memo 1980-216.
• Residential property held for sale, then rented, capital gain on eventual sale, indicia that developer effectively changed his mind by removing property from real estate listings, renting property, failing to maintain “For Sale” sign. Yamamoto, T.C. Memo 1986-316.

 

There Must Be Very Clear Evidence That The Owner Has Changed His Mind

I think a prudent course of action would be for Mr. Wentworth to set up a new entity, preferably a single-tax (passthrough) entity like an LLC.  This new entity could be called Greenacres Holding Trust, LLC (for purposes of this memo, “Holding”), or something like that.  Mr. Wentworth should convey Greenacres to Holding.

I believe that if Holding simply sits on the property and engages in no real estate development activity of any kind, Holding should not be classified as a dealer in real estate and Greenacres will not be inventory.  Accordingly, if and when Holding makes a charitable gift or a bargain sale of Greenacres, we have a very supportable position that the deduction should be for the full market value of Greenacres and not limited to basis.

 

Option to Purchase and Rev. Rul. 82-197

(This was actually part of the discussion and part of the memo to the client.  Note #15 was in large part about Rev. Rul. 82-197).

Rev. Rul. 82-197 may be a very useful planning tool for this transaction.  We have relied on this revenue ruling in other transactions in which a landowner (individual, corporate, whatever) commits to make a charitable contribution of a conservation easement, but for whatever reason is not willing to make the donation currently.  Generally, the revenue ruling says this:  if Holding enters into an option to sell the property to a government agency or a charity at a bargain, the income tax deduction for the bargain sale is not available at the time the option is entered into but is available in the year in which the property is sold.

Accordingly, say Holding enters into an option agreement with Tax-Exempt Conservation Buyer later this year under which Buyer can acquire the property at a bargain purchase price say between thirteen and twenty months after Holding takes title.  According to the revenue ruling (and also according to good tax sense), Holding does not get a deduction this year for the bargain sale, but assuming the option is exercised according to its terms Holding gets the deduction in a later year.  This will give Holding the opportunity to “sit” on the property for a year or more, do nothing, and avoid being characterized as a “dealer” in real estate.  Note that the proposed “waiting period” is time to allow the property to avoid “inventory” classification and is not related to the “holding period” rule.

See also the excerpt from IRS Publication 561, separately sent to you; I think that conclusively supports this planning approach.  (See Note #15 for a longer discussion of Rev. Rul. 82-197 and IRS Publication 561.)

 

Structure/Tax Return/Tax Filing Issues

Open for discussion:  whether or not Holding should be a separate entity, with a separate tax return filing, or possibly a single-member LLC that is a disregarded entity for federal income tax purposes.  We should discuss this with Mr. Wentworth’s other tax advisors and his tax return preparers.  We may want Holding to file a separate return so it can separately report any deduction that will flow through to Mr. Wentworth, but this may need some discussion.  (Since I originally prepared this memo, there has been significant advice from IRS on certain appraisal issues when real estate is owned by a single-member LLC that is a disregarded entity for federal income tax purposes.  Although these issues are both beyond and outside the scope of this Note, I have included a link to the relevant IRS Chief Counsel’s Advice.)

 

Approvals

The law is clear that it is not necessary for the landowner to have obtained all necessary development permits and/or approvals for an appraiser to be able to establish “fair market value” for purposes of an income tax deduction for a charitable gift of real estate.  The tax cases are clear that the appraiser needs to be able to say there is a reasonable probability that such approvals will be available; naturally, the ability to reach that conclusion will depend on the level of proposed development, and of course will vary from property to property and jurisdiction to jurisdiction. When I work on a particular case I like to raise the standard for the appraiser to a “high likelihood.”  However, see the case of Stotler v. Commissioner, T.C. Memo 1987-275, previously sent to you, where the appraisal was based on a development plan that had not been approved but was deemed to be approvable.  See also “Valuation VDP,” below.

Finally, you have asked how I would go about helping to develop an appraisal of the “fair market value” of the property.  (For income tax deduction purposes, fair market value is essentially defined as what a willing and knowledgeable buyer would pay a willing and knowledgeable seller, or, put another way, what you would get if you put the property on the market and sold it.)  As with the dealer/non dealer cases, I can give you a longer answer if you would like but for today I will leave it with the following brief discussion.

 

Valuation VDP

As noted in my earlier memo to you, I bring together a team of experts who understand the particular property and the relevant zoning and regulatory rules, an appraiser who understands the relevant real estate market and what current buyers like, and, when the matter calls for it, a review appraiser.  We test possible development plans for the property (high density, medium density, low density, other variations), consider market issues and values and infrastructure costs, and value a few different development possibilities.  The goal of this process is to come up with a Virtual Development Plan (“VDP”) for the property that every expert on the team is willing to say would be approved if submitted and would be suitable for that particular market.  In some jurisdictions this is a simpler process; in some jurisdictions it is more difficult.  Simply put, the VDP gives us the answer to the question, “If a buyer wanted to develop the property and realistically make the most possible money, what would that development plan look like?”

This is a hypothetical planning process only:  we are not going to seek approval for any development plans.  This is all in-house, around the conference table planning, for valuation purposes only.

But even though this is a hypothetical planning process, it does involve very real planning and serious work.  To reach the answer often requires some testing, and, again, this is very market-specific.  For purposes of illustration only, assume we have a 100-acre property in a 2-acre zoning jurisdiction.  Is the highest and best use fifty 2-acre house lots?  What would they sell for?  How long would it take to sell them?  What would it cost to put in roads and other improvements for fifty houses?  How long would it take to get the approvals?  Is the highest and best use not fifty 2-acre lots but rather ten 10-acre lots?  Five 20-acre lots?  Is there a premium higher price in that market for large, estate lots?  Are infrastructure costs so high that it pays to put in fewer improvements and sell fewer lots?  These are not make-believe questions; these are real questions that engineers and appraisers can answer, and the planning team can run the valuation numbers based on the answers.

I have been through this process many times over the years, and I can tell you that it is a great way to go about this work and the process produces a very supportable number.  The process also produces a detailed development plan that becomes part of the qualified appraisal report Mr. Wentworth will need to substantiate the income tax deduction for the gift.

 

Proposal

Accordingly, here is what I recommend and propose:

1. I will work with you to restructure ownership and on all of the issues related to tax planning.

2. I will assemble with you and run with you a project team to review all land use, regulatory, market, and valuation issues in connection with determining the fair market value and highest and best use of the property.  The goal of the project team is to do all of the extensive internal planning work necessary to support that a “highest and best use” and “fair market value” conclusion and, accordingly, to support the appropriate income tax deduction for a charitable donation of the property.  The team may include a number of people, including a real estate attorney who understands the local development and regulatory process; a local engineer and/or land use planner who understands the regulatory and development process; an experienced local appraiser who is familiar with the local market; and a review appraiser who has extensive experience with the valuation of real estate and the drafting of a qualified appraisal report for purposes of substantiating a charitable gift income tax deduction.

3. Working with you, I will coordinate continuing communication and a series of meetings and conference calls (as necessary) among project team members until we have determined the highest and best use of the property and a reasonably close range of its fair market value.  I will also visit the property at least once.  The valuation exercise will be coordinated with Mr. Wentworth’s income tax planning people and tax preparers as far as determining what year to make the gift.

4. I will identify (with you) and work with an appropriate donee organization for the property.

5. I will review a draft (or drafts) of the final appraisal, and work with the appraisers to see to it that the appraisal, once completed, meets the relevant tax law requirements as a “qualified appraisal.”  Once the appraisal is complete, I will prepare Form 8283, Noncash Charitable Contributions, required by the IRS.  I will coordinate and oversee charitable donation substantiation in accordance with federal requirements.

6. I cannot warrant or represent what the value of the gift will be.  However, I will work with the appraisers to see to it that we take advantage of planning opportunities in this regard.

7. I cannot at this point warrant or represent that the property will be classified as a capital asset, although I believe I can recommend a structure for the gift that seems likely to result in that classification.

 

It’s Really More Complicated Than That

See the article I wrote for the publication Tax Notes more than a decade ago, “Proper – and Improper –Deductions for Conservation Easement Donations, Including Developer Donations.”  It is highly tax-technical, and many readers of this Note will not be interested in going into such technical detail.  However, the points I made when I wrote the article are still correct, and still relevant, today.  The bottom line is that in many cases, a developer is simply not in the position, either financially or from the perspective of overcoming the income tax hurdles, to turn a piece of development property into a meaningful federal income tax deduction, either with an outright gift or with a conservation easement donation.

 

On The Other Hand

Once or twice I have run into a different set of facts with a real estate developer.  As they say, care must be taken, but if the facts are real some of the planning hurdles are easier.

My favorite example of this situation came years ago when I was approached by the developer of a major resort.  The resort included thousands of acres.  The project had been under way for years, was expected to continue for years, and was very successful.

The ownership included a small environmentally-important parcel, less than 400 acres, at one end of the resort.  It could have easily been developed into a number of high-end homes.  Instead, the owners wanted to put a conservation easement on the entire parcel.  In all of their planning, nothing had been done with this parcel.  There were no roads, no utilities, no lot lines, no dirt had been turned, no plans had been filed.  This particular parcel was clearly not “inventory” property at that time (although we had to be certain to confirm and memorialize that in our work).

Shortly after I began work, I said to one of the principals, “Tell me, you guys are capitalists, you have a very successful resort development here, you could easily develop this property.  Why are you donating an easement on it?”

I have cited his response many times to many people.

“We have 800 fully permitted lots in inventory,” he said, “and we control and time the release of those lots to keep prices stable, and high.  Even though this property could easily be developed now, or certainly within the next year, we have no current plans to develop it because we have our hands full.  We joke among ourselves that we might get to it in ten years.  We decided that the present value of an income tax deduction now is worth a lot more to us than the present value of developing this property in a decade.”

 

Valuation:  A Cautionary Note

In some of these cases, but not all, the value of the property is not what the owner thinks it is, or hopes it is.  Keep in mind that many of these cases of conservation donations by a real estate developer occur when the economics of the contemplated development change, that is, when real estate values stagnate or drop, or when the developer runs into significant regulatory hurdles or even opposition.  Sometimes a conservation donation becomes a viable option at that point.

In many of these cases the property owner still thinks, or hopes, that the value of the property is unchanged from what it was when it was first acquired, or is even higher.  Of course, this may be true, but the value of a parcel that fails to move successfully through the development process, for whatever reason, is likely to be lower than the value would be if the development actually materialized.  I have seen proposed donations accompanied by a detailed master plan for a development that might have been realistic once, but is no longer realistic.

Of course, every property is different, and every market is different.  But remember that for federal income tax charitable deduction purposes, fair market value is defined as what a willing and informed buyer would pay a willing and informed seller NOW, at the time of the current gift.