As real estate developers, investors, and business owners minimizing ordinary income tax is crucial to retain more of your profits and optimize financial outcomes. There are various business strategies that can help you achieve this goal while complying with applicable tax regulations. One of these strategies includes preserving capital gains on real estate development transactions by examining the structure of using separate legal entities for land appreciation and development. This approach can offer significant advantages, including tax optimization, risk management, and flexibility.
Real Estate Development and Ordinary Income Tax
Ordinary income tax applies to the earnings generated through regular business activities, such as rental income, development profits, and other operational income in real estate. Reducing or avoiding ordinary income tax is vital for developers since it can significantly impact the bottom line. The federal married filing jointly (“MFJ”) ordinary income tax rates for individuals in 2023 are as follows:
10%: Up to $22,000 of taxable income
12%: $22,000 to $89,450 of taxable income
22%: $89,450 to $190,750 of taxable income
24%: $190,750 to $364,200 of taxable income
32%: $364,200 to $462,500 of taxable income
35%: $462,500 to $693,750 of taxable income
37%: Over $693,750 of taxable income
Understanding Capital Gains
Capital gains refer to the profit earned from the sale of a capital asset, such as real estate, stocks, or other investments. For real estate developers, capital gains represent the difference between the property’s purchase price and the selling price. It’s important to differentiate between short-term capital gains (assets held for one year or less) and long-term capital gains (assets held for more than one year). The tax treatment of these gains differs significantly, with long-term gains typically being taxed at a lower rate.
Short-Term Capital Gains: Assets held for one year or less are subject to the ordinary income tax rates.
Long-Term Capital Gains: Assets held for more than one year enjoy preferential tax rates, which are generally lower than ordinary income tax rates. The long-term capital gains Married Filing Jointly (“MFJ”) tax rate is 15% when taxable income is $553,850 or less and 20% when taxable income is more than $553,850
Preserving capital gains is essential for real estate developers because it directly impacts the overall profitability of the project. By minimizing taxes and optimizing gains, developers can allocate more resources to future projects, expand their portfolio, or reinvest in their business. There are several effective strategies to achieve this goal.
The Dual-Entity Structure: Land Appreciation and Development
The dual-entity structure involves using two separate legal entities for distinct phases of a real estate project:
a. Entity A: Land Holding Entity – This entity is primarily responsible for acquiring and holding land. Its primary objective is to benefit from land appreciation over time. The land holding entity typically generates minimal or no income during the holding period and focuses on capital growth.
b. Entity B: Development and Sales Entity – This entity takes over the active development, construction, and marketing of the real estate project. Its main goal is to generate income through the sale or lease of the developed property.
Advantages of the Dual-Entity Structure
a.Tax Optimization: One of the key benefits of this approach is the ability to optimize taxes. By segregating the land appreciation from the active income generated during development and sales, developers can manage their tax liabilities more efficiently. The development activities will be subject to ordinary income tax rates. However, the land appreciation will be subject to the lower capital gains tax rates.
b. Capital Gains Tax Deferral: The land holding entity can also utilize strategies like 1031 exchanges to defer capital gains taxes when acquiring new properties or transitioning to other investments. This allows developers to continually grow their land portfolio without triggering immediate tax liabilities.
c. Reduced Ordinary Income Tax: The development and sales entity can focus on generating ordinary income, which may be subject to higher tax rates. By separating this income from the land holding entity’s capital appreciation, developers can potentially minimize their overall tax burden.
d. Risk Mitigation: By using separate legal entities, developers can isolate potential liabilities. For instance, if a legal issue arises from the development and sales activities, it is less likely to affect the land holding entity’s assets and vice versa.
e. Flexibility in Exit Strategies: The dual-entity structure allows developers to explore various exit strategies for their projects. They can choose to sell developed properties, sell land parcels individually, or even retain land for long-term appreciation, depending on market conditions and their investment objectives.
f. Timing and Coordination: It’s crucial to plan the land sale and the commencement of development activities in sync. Proper coordination between the land holding entity and the development entity is essential to facilitate a smooth transaction.
Selling Land at Fair Market Value
As part of the dual-entity structure, the land holding entity, which focuses on capital appreciation, can sell the land to the development entity at its current fair market value. This transaction should occur before the development and construction activities begin. By doing so, the land holding entity realizes the appreciation in the land’s value and converts it into a capital gain.
2. Advantages of Selling Land at Fair Market Value
a. Preserving Capital Gains: The sale of land at fair market value enables the land holding entity to capture the accumulated appreciation as a capital gain. This gain can be deferred or reinvested using tax-deferral strategies like 1031 exchanges.
b. Reducing Ordinary Income Tax: As the land holding entity generates capital gains instead of ordinary income through the sale, the overall tax burden can be reduced. Capital gains are taxed at the more favorable rates than ordinary income.
3. Considerations for the Transaction
a. Fair Market Value Assessment: The land sale should be conducted at a fair market value to ensure compliance with tax regulations and avoid any potential issues with the tax authorities. Engaging a qualified appraiser can help determine the accurate fair market value of the land.
b. Timing and Coordination: It’s crucial to plan the land sale and the commencement of development activities in sync. Proper coordination between the land holding entity and the development entity is essential to facilitate a smooth transaction.
c. Legal and Tax Advice: As with any real estate transaction, developers should seek advice from legal and tax professionals to ensure proper documentation and adherence to tax regulations.
Utilizing an Installment Sale
An installment sale is a transaction in which the seller receives payments from the buyer over an extended period rather than in one lump sum. In the context of real estate development, the land holding entity can sell the land to the development entity through an installment sale agreement. The payment for the land is then received in multiple installments, allowing for the deferral of capital gains tax and providing developers with a steady cash flow over time.
Advantages of an Installment Sale
a. Deferral of Capital Gains Tax: By spreading the receipt of payment over several years, the installment sale enables the land holding entity to defer the recognition of capital gains tax. This deferral can free up funds for reinvestment in other projects or assets.
b. Reduced Tax Liability: As the tax liability is spread over the installment period, developers may be subject to lower tax rates due to being in a lower tax bracket. This can result in overall tax savings compared to a one-time lump sum payment.
c. Enhanced Financial Flexibility: The installment sale provides developers with a steady stream of income over time, which can be beneficial for financing other projects, meeting ongoing business expenses, or making strategic investments.
Preserving capital gains on real estate development transactions is a multifaceted endeavor that requires careful planning and a comprehensive understanding of tax regulations. The dual-entity structure for real estate development, where one entity focuses on land appreciation and the other on development and sales, offers several benefits for preserving capital gains and optimizing tax outcomes. By segregating capital appreciation and active income, developers can take advantage of various tax-deferral strategies and mitigate risks. However, it’s essential to seek professional advice and ensure effective coordination between the entities to make the most of this strategy. So if you find yourself buying, selling and developing a lot of property for your business, it is in your best interest to consider the dual entity structure. With a little upfront planning, you can significantly reduce your tax liability and improve your bottom line!
Please let us know if you have questions concerning dual entity structures or any related concepts, we can be reached at (480) 980-3977!