31.2 Sales of Subdivided Land—Dealer or Investor?

An investor faces a degree of uncertainty in determining the tax treatment of sales of subdivided realty. In some situations, investor status may be preferred, and in others, dealer status.

Planning Reminder

Installment Sales

The distinction between an investor and dealer is significant if land is sold on the installment basis. Investor status is preferable if you want to elect the installment method. Dealers may not elect installment sale treatment (5.21).

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Capital gain on sale.

Investor status allows capital gain treatment. Capital losses may offset the gains. For capital gain, an investor generally has to show that his or her activities were not those of a dealer but were steps taken in a liquidation of the investment. To convince an IRS agent or a court of investment activity, this type of evidence may present a favorable argument for capital gain treatment:

• The property was bought as an investment, to build a residence, or received as a gift or inheritance.
• No substantial improvements were added to the tract.
• The property was subdivided to liquidate the investment.
• Sales came through unsolicited offers. There was no advertising or agents.
• Sales were infrequent.
• There were no previous activities as a real estate dealer.
• The seller was in a business unrelated to real estate.
• The property was held for a long period of time.
• Sales proceeds were invested in other investment property.

Section 1237 capital gain opportunity.

Section 1237 is a limited tax provision that provides a capital gain opportunity for subdivided lots only if arbitrary holding period rules and restrictions on substantial improvements are complied with. For example, the lots must generally be held at least five years before sale unless they were inherited. If the lots were previously held for sale to customers, or if other lots are so held in the year of sale, Section 1237 does not apply. Furthermore, substantial improvements must not have been made to the lots. According to the IRS, a disqualifying substantial improvement is one that increases the value of the property by more than 10%. The IRS considers buildings, hard surface roads, or utilities, such as sewers, water, gas, or electric lines, as substantial improvements.

Interest expense deductions.

The distinction between an investor in land and a dealer is also important in the case of interest expenses. Dealer status is preferable here. Interest expenses incurred by an investor are subject to investment interest deduction limitations; see Chapter 15. On the other hand, interest expenses of a dealer in the course of business activities are fully deductible; see the Morley Example below.

Passive activity.

Income from sales of lots is not considered passive activity income. Thus, losses from sales of land may offset salary and other investment income. If you hold rental property and also sell land, make sure that your accounts distinguish between and separate each type of income. This way income and losses from land sales will not be commingled with rent income subject to the passive activity restrictions discussed in Chapter 10. Your activity in real property development counts towards qualifying you as a real estate professional who may deduct rental losses from nonpassive income if material participation tests are met (10.3).