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Normally when real property is subdivided and actively sold, the gain on the sale of the property is subject to ordinary income tax treatment. However, in certain circumstances the taxpayer may be able to claim capital gain treatment under the five- or ten-year rule under Sec. 1237, even if the real property is subdivided into lots and the taxpayer actively tries to sell the parcels.

Five-year rule

To take advantage of the five-year rule the taxpayer must meet the following conditions (SEC. 1237(a)):

  • No portion of the tract has ever been held for sale in the ordinary course of the taxpayer’s business;
  • No other real estate was held for sale to customers in the year of sale;
  • No substantial improvements have been made on the tract that materially increased the value of the lot sold; and
  • The property must have been owned by the taxpayer for five years, unless the taxpayer inherited it.

Most taxpayers do not qualify for capital gain treatment under the five-year rule because they do not meet the substantial improvement requirement, which includes installation of hard surface roads or utilities such as sewers, water, gas, or electric line (Regs.Sec.1237-1(4)).

10-year rule

Under the 10-year rule, the taxpayer can receive capital gain treatment even though improvements were made to the property. A taxpayer can elect to have substantial improvements treated as necessary and not substantial if all 

of the following conditions are met (Sec. 1237(b)(3) and Regs. Sec. 1.1237-1(c)(5)(i)):

  • The taxpayer held the property for 10 years;
  • The improvements consist of the installation of water, sewer, or drainage facilities, or roads, including hard-surface roads, curbs, and gutters;
  • The IRS is satisfied that the improvements were necessary and that without the improvements the lot’s fair market value would be less than the prevailing price for similar building sites; and
  • The taxpayer elects not to adjust the basis of the lot sold for the cost of those improvements as well as not to deduct any part of the cost as an expense.

Should you make the election?

At first it may seem beneficial to make the election to treat improvements as not substantial, since you cannot include the cost of these improvements in the basis of the asset and cannot deduct the correlating cost as an expense. There may be a significant tax benefit to making this election if the taxpayer anticipates a sizable gain on the sale and has a substantial capital loss to minimize the tax liability on the capital gain, or if there is a considerable difference between the taxpayer’s marginal tax rate for ordinary income and capital gains and the improvements were low in cost compared to the value of the lot.

Unimproved land

A taxpayer may be able to maintain investor status even if the property is subdivided and sold off incrementally. Sec.1237 allows the property to not be treated as held primarily for sale to customers in the ordinary course of business and the taxpayer can report the income using installment sale treatment under Sec 453, since this provision applies to capital gain and not ordinary course of business. Under the installment sale treatment, the gain can be deferred until the installment payments are received. The gain may also be deferred under the like-kind exchange provisions of Sec. 1031, because it does not apply to property that is considered inventory but instead to property that is an investment. 

Recent court case: Rogers

In the recent Tax court case, Rogers, T.C. Memo. 2018-53, the taxpayer argued that the land transferred as a capital contribution to his business and then sold in subdivided lots should be taxed as a capital gain under Sec. 1237. The court refused to address the issue because it was not properly raised, the court indicated that it did not agree that Sec. 1237 would apply. Because the taxpayer originally reported the revenues as ordinary income and included the costs of improvements in the basis of the lots, which is contrary to Sec. 1237 rules. The decision to apply Sec. 1237 on the property must be made before the property is sold.

In conclusion, Sec. 1237 can generate substantial tax savings if the appropriate conditions are met, and by planning accordingly.