Strategic Condo Conversion Planning Can Yield Considerable Tax Savings

By W. Michael Howlett, Partner, Cherry, Bekaert & Holland, L.L.P. | bio

An extended version of this article appeared as "Conversion Conundrum" by W. Michael Howlett in the September 2007 issue of Urban Land. Reprinted with permission from the Urban Land Institute.

During the recent residential housing boom, many apartment building owners converted their apartments to condominiums. Though the market has cooled a bit over the last year and a half, interest in condo conversions remains strong. But with the current downward pressure on prices and the increased expectation of seller assistance on closing costs, property owners need to reexamine the potential income tax cost associated with these conversions.

Properly structuring a condo conversion can yield capital gains instead of ordinary income, subjecting earnings to the 15% federal capital gains tax rate as opposed to the 35% top ordinary tax rate. When successful, these savings can restore much of the luster that has been lost due to softening market conditions.

However, capital gains treatment is only available as an option in those instances where individuals own a property either directly or indirectly via a pass-through entity (i.e., partnership, LLC or S corporation). It is also important to note from the outset, especially with apartments, that the portion of the capital gain attributable to the depreciation taken is subject to a 25% tax rate.

Avoiding dealer status is generally the key to achieving capital gains treatment for the sale of property. Section 1221 of the Internal Revenue Code disallows capital gain treatment for the sale of property held by a taxpayer primarily for sale to customers in the ordinary course of business. Whether property is being held for sale in the ordinary course of business is very dependent on facts and circumstances. Over the years, published IRS rulings and decisions rendered by the courts have developed several factors used to make this determination. They are:

• the frequency, number and substantiality of sales;
• the taxpayer’s intent or purpose for the purchase of the property;
• sales and marketing activities undertaken by the taxpayer either directly or through the use of brokers or agents; and
• the extent of subdividing and development of the property to increase its value.

There is no decisive single factor. Instead, the characterization usually hinges upon the cumulative effect of the taxpayer’s actions under each of these four factors, with sales and marketing activities and the frequency of sales as two of the more critical criteria. However, there is a planning technique, sometimes called the orderly liquidation approach, that depends on the prior rental use of a property to overcome the number and frequency of sales concern.

As with any facts-and-circumstances-driven planning technique, there are favorable as well as unfavorable rulings to consider, but the orderly liquidation approach receives support from some very favorable case law. The approach relies on the owner’s ability to show that the conversion to condos and the sale of the condo units can be classified as the orderly liquidation of trade or business assets (i.e., rental property) and not a change of status to being in the trade or business of selling condominiums.

It is possible to have a high number of sales and not necessarily be viewed as having sales in the ordinary course of business. As with any fact-based argument, extreme care must be taken to apply these cases to your situation. A careful reading of the facts of the cases and comparison with your situation is a must.

Another avenue to explore that may yield the desired result of capital gains treatment is to sell the apartment building to another entity prior to converting it to condos. A sale at market value will trigger the gain in the entity that held the property for rental purposes, and that gain will be subject to capital gains rates. The key to this strategy is that there must be a business reason, aside from tax planning, behind the sale. Two of the most common reasons would be the desire to limit liability exposure and the involvement of different partners in the sales activity.

In addition to the normal issues faced whenever contemplating a sale to another entity, such as arm’s-length dealing, avoiding agency relationships and establishing a business purpose, the sale of an apartment building to an entity that will convert the property to condos and market them for sale has one additional hurdle – Section 1239 of the Code.

Section 1239 recharacterizes what would normally be capital gain into ordinary income when a related party acquires depreciable property. However, there are two possible ways to deal with this rule. The first is to plan to avoid the related party designation. In this case, if more than 50% of the ownership of the two entities is under common control, then they are considered related. This keeps owners from spreading ownership across various family members to avoid the related party rules. For example, if a father owns 40% and his son owns 20%, they are each deemed to own 60%. However, some family relations (e.g., step-parents and in-laws) fall outside the rule's definition. Therefore, 50% of the entity buying the apartment building must be unrelated to the existing ownership.

At first glance, it would appear that this hurdle would be insurmountable. Why give away 50% of the profit to a new partner in order to get a better tax rate? Though a new 50% partner would have to be found to participate in the condo sales entity, that new partner would not be getting 50% of the overall profits. Most of the profit would be triggered in the existing entity that owns the property. In selling the building to the condo sales entity, the price would normally capture most of the profit back in the rental entity.

Also, look at whether the property fits the definition of depreciable property. A literal interpretation of Section 1239 implies that the property is depreciable in the hands of the acquirer. Since the entity acquiring the property intends to convert it to condos and sell the units, it can be argued that the acquiring entity is a dealer with respect to the condos. Therefore, the condos are dealer property and are not depreciable.

Until now, we have stressed trying to avoid dealer status. With this last approach, however, you want to be very clear that the acquiring entity is a property dealer. By choosing this approach, the related party rules under 1239 are rendered moot, making it possible to use identical or nearly identical ownership to the selling entity. While this strategy is consistent with the wording of Section 1239, there is no case law at present to either support or deny this position.

A conversion from apartments to condos does not automatically taint what would have been a capital gain and convert it to ordinary income, but preserving capital gain status cannot be assumed. Several avenues do exist that can be employed to structure your conversion to either preserve capital gains treatment or to claim most of the profits as capital gains. Each approach has its own strengths and pitfalls, so proper planning with your CPA is essential in order to maximize your potential tax savings.

Mike is a Tax Partner with Cherry, Bekaert & Holland, L.L.P. (CB&H) and a member of the Firm's Real Estate and Construction Industry Group. He can be reached at 757.456.2400 or via email at mhowlett@cbh.com.