Tax Implications of 6+ Land Contracts

[Scott M.]

Hey all -

As I understand it one person or company can complete 5 land contracts and only be taxed on the actual payments (installments of say $1,000 / month).

However - if one person or company does 6 or more land contracts (not in a year but total) you are taxed on the face value of the land contract the year the land contract is created. (say $100K).

From a legal point of view I have heard that 50% of the time the IRS wins cases and loses 50% of the time when they audit people / go to court / with those who do more then 6 but do not claim the face value as income in the year the land contract was created.

I have also heard there are ways around this rule - but nothing concrete yet - anyone here have any knowledge on this topic?

[Don James]

I happened to be researching land contracts and stumbled onto this forum. Here is some addtional info that may help. As I understand the question, it seems to revolve around "dealer vs investor". We have had situations where we were able to secure investor status for real estate dealers. It involves the particular facts and intent of the related investment.

Factors Considered in Determining Dealer Status:

To determine dealer status of the taxpayer and therefore the proper character of income (ordinary vs. capital gain), three questions must be answered: (a) what is the taxpayer’s trade or business? (b) did the taxpayer hold the property primarily for sale in that business? and (c) were the sales “ordinary†in the course of that business? The Supreme Court held that “primarily for sale†means “of first importance†or “principally†(Malat v. Riddell). Sales are “ordinary†if they are normal for the business, which may be indicated by their frequency and substantiality (Suburban Realty Co.).

Whether property is held primarily for sale to customers in the ordinary course of business is a facts and circumstances determination. Among the facts to consider are the following (Norris):

a. Owner’s intent (i.e., nature and purpose for which the property is acquired).

b. Extent of improvements and advertising to increase sales.

c. Number, frequency, and substantiality of sales [this is generally the most important factor (Suburban Realty Co.; Hancock)].

d. Duration of ownership.

e. Continuity of activity related to sales over a period of time.

f. Extent and nature of the efforts to sell the property.

g. Extent of subdivision and development to increase sales.

h. Use of a business office for the sale of the property.

i. Character and degree of supervision or control over representatives selling the property.

No one factor or combination of factors is determinative. Each individual case must be considered in its entirety to determine whether the property conveyed was held primarily for sale in the ordinary course of business, and thus, dealer property (Cole v. Usry; Cottle; Buono).

Intent at the Time of Sale While one of the factors to be considered is the seller’s original intent, the courts consistently place the most weight on the seller’s intent at the time of sale (Jersey Land & Development Corp.; Daugherty). Therefore, an original intent to hold property for investment does not guarantee capital gain (or loss) if the circumstances change. Thus, when a taxpayer subdivides and develops a tract that was initially purchased as an investment, this is strong evidence for ordinary income treatment (Biedenharn Realty Co.). (However, see paragraph 702.28 for an exception to ordinary income treatment in limited situations.) Likewise, a development purpose at acquisition does not forever preclude capital gain treatment. A taxpayer may decide to hold for investment property that was initially purchased for sale to customers in the ordinary course of business. A sale of this property would result in capital gain (Maddux Construction Co.).

Supporting a Change to Investment Purpose In general, changes of intent fall into one of two categories—voluntary and involuntary. As expected, a voluntary change from development to investment is more difficult to sustain than an involuntary change. The courts tend to view voluntary changes as responses to increased economic opportunity (even if the taxpayer has no control over such economic opportunity). Though not sufficient to guarantee capital gains treatment when trying to establish a change from development to investment, the following involuntary factors tend to support a favorable taxpayer outcome:

a. Pressing need for cash.

b. Illness or old age.

c. Necessity to liquidate a business upon the death of an owner.

d. Unfavorable zoning changes.

e. Threat of condemnation.

f. Inability to obtain anticipated zoning changes.

g. Property is unfit for original purpose.

h. Acts of God.

Taxpayers with “Dual Status.†A taxpayer is usually considered either a “dealer†or an “investor.†This distinction between dealer and investor is important in establishing the nature of a taxpayer’s business. Even so, a dealer can hold investment real estate, and an investor can hold real property for sale to customers in the ordinary course of business (Tollis). This “dual status†is possible because the proper tax treatment does not depend on whether the taxpayer is, on an overall basis, a dealer or an investor. Classification of income as capital or ordinary gain is decided property-by-property, based on the statutory determination of whether the property is a capital asset or property held for sale to customers in the ordinary course of business.