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?

[David Collins]

Scott, very generally speaking, the "occasional investor" can sell property using the installment method for tax purposes (reporting gain only when and as the cash is received), whereas a "dealer" must report the entire gain in the year of the sale.

Clearly, the dentist who infrequently dabbles in property deals can get installment treatment for his gains, whereas the chap whose sole source of income is his full-time business of doing property deals is a "dealer". But in between those two obvious extremes, where's the line drawn?

There's no bright-line test which unambiguously determines whether one is a 'dealer' or not. (There is a 5-lot max rule in Code Section 1237 (h)(1) which you might be thinking about, but it relates to development activities.) The dealer-or-casual-investor is a huge facts-and-circumstances issue.

In a previous life as a tax advisor, I spent many hours sifting through numerous Tax Court cases in which this issue was debated. Bottom line is the particulars of any given situation will determine the outcome.

Best bet is to have a tax pro--one with experience in this area--advise you based on your particular situation. Next best bet: There's a boatload of 'dealer-vs-casual-investor' info on the 'net, thanks to the popularity of the issue. Many law firms and CPA houses have published articles on the topic. Peruse some of these, and you'll get a good feel for the factors that are used in making that determination.

Best of luck!

...it was early and I was full of no coffee...

[Dave Toelkes]

Originally posted by David Collins:

There's no bright-line test which unambiguously determines whether one is a 'dealer' or not.

Look at IRC § 453 which defines a "dealer dispostion" as ANY disposition of real property held for sale to customers.

I would argue that the word ANY in this definition sets the "bright-line test" at one.

[Scott M.]

I have spent some time researching this and while I am waiting back on an answer about a local/state rule I can say with confidence there is not federal rule.

What I have also learned from several leading experts is that it depends on the “intent†of the property at purchase…meaning there are those who have had to pay up to the IRS on their first land contract as their intent was to sell it when they bought it VS there are people who have many land contracts but only pay on the installment basis because their intent was to rent or do something else with the property when they bought it – so cases that go to an audit seem to come down on intent.

I am not a tax expert by any means but that is what I have learned to date….still learning on this topic.

[David Collins]

Sec 453 certainly gives the impression of drawing a bright line for us--at first glance, anyway. That bright line gets smudged into near oblivion when one then tries to deal with the "real property held for sale to customers" portion of the definition.

That's when you get into that "intent" factor that Scott has been hearing about. If the requisite "dealer intent" is established by IRS / court, then 453 steps in with a clear and unambiguous result, as you suggest. But 453 can't come to the party in the first place until such intent is established, and that's where it comes down to a facts-and-circumstances determination.

Scott, that's why the results of your homework so far, from the experts you've consulted, indicate that it hinges significantly on that subjective intent factor.

[Corey Demuth]

what exactly is a "land contract" ?

[Scott M.]

Well David and Dave - I guess the next question is how to you cover your tracks on "intent".

I mean if I "intend" to rent 100 homes but all 100 homes end up on a land contract....well you get it - so - how is "intent" determined in your experience and how does one protect themselves from this.....

[Scott M.]

Corey - I am sure others will come in and use bigger words - but basically a land contract is a way to sell a property with seller financing.

If I own a property and I sell it to the buyer they can go get their own financing or I can offer them financing through me.

I can charge an interest rate and get a monthly payment just as a lender would.

Or I could sell it on a lease with option to buy - but that is just a lease until they buy it.

A land contract is a sale the moment you close - they now own the property and you (the seller) now own the note/motrgage

[Corey Demuth]

Oh okay, so why is there a limit on how many of those you can do?? I would think, especially now given the hesitation of banks to help people get into homes, that it would benefit all if more of this type of financing were available...

[Scott M.]

Your trying to find logic in the tax code?

[David Collins]

Corey, the limit that I mentioned in the second post--dealing with Code Sec 1237--doesn't relate to land contracts, but rather to developers. I only suggested that maybe it was the limit (5 lots max) that Scott had heard about. Incidentally, that provision isn't a ceiling on how many lots you can develop. It simply provides a threshold that allows small, 'one-time' development activities to use simpler and more favorable tax rules than those which apply to the 'professionals'.

Scott, a determination of "intent" usually comes down to actions and documentation. Nothing is off limits from being taken into consideration. For example, if you had paid a consultant for a rental feasibility analysis as a part of your acquisition DD, and immediately upon acqusition you began marketing efforts to some extent to acquire tenants, a court would probably find that you bought the property with a primary intention of renting it.

On the other hand, selling a call option on the property or negotiating for its resale as soon as you buy it (or even before) would make it difficult to escape a "flip" intent ruling.

Unfortunately, it's very facts and circumstances-ish. There isn't a well-defined list of things you can do to bulletproof (or absolutely sabotage) your desired tax consequence. There is, though, a large body of literature on the subject (court cases, IRS rulings, expert commentaries), and if it comes down to a critical issue involving significant bucks, it'll likely be a good investment to pay a tax pro to advise you based specifically on your particular fact set.

Best of luck with it!

[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.

[Scott M.]

Hey Don - I wanted to thank you for your post - very informative - I need to take a bit to digest what you have written and I will prob. have some questions.

But welcome to the forums and thank you for all the info - really great stuff!

[Dave Toelkes]

Scott,

There is no "five deal" rule in the IRS tax code. I believe some states have a five deal rule as a threshhold for whether an individual or a business needs to obtain a business license to continue operating in that taxing jurisdiction.

The issue at the center of the "five deal rule" is a business license and not installment sale tax treatment.