Everyone knows the story: the visionary investor spots the undervalued property, negotiates a favorable deal, holds the asset patiently, then sells just at the right moment, banking a huge profit.
Other, less sexy aspects of the process, like filing the taxes, are usually left out.
But in today’s red-hot market, with prices breaking records nearly every quarter and copiers running out of ink printing investment sales contracts, some aspects of real estate taxation – such as the 20 percent difference between federal long-term capital gains tax and ordinary income tax — can begin to have a major impact on bottom lines.
Investors – and, according to experts, some developers – are taking advantage, claiming lower rates even under questionable circumstances, relying on the Internal Revenue Service’s relatively weak enforcement to keep them out of serious trouble.
The stakes
Whether an investor pays the roughly 20 percent capital gains tax rate or the roughly 40 percent ordinary income tax “can be a very very large issue,” said Richard Wolfe, a partner in the tax department at Fried Frank. “It’s a not-insignificant part of what I do for a living. It comes up all the time, in a variety of contexts.”
From left: Richard Wolfe and Jesse Keenan
Here’s how it works: If you intend to buy an asset and flip it promptly, you’re a dealer and your profits are taxed as ordinary income. If you’re seeking capital gains treatment, you must buy with the intention of holding the property as an investment or with the intention of holding the units as rentals. Short-term capital gains are taxed like ordinary income, but long-term gains, on properties held for over a year, are taxed at the lower rate.
If 20 percent of profits sounds like a big deal, that’s because it is.
“The dollars can be huge,” said Wolfe.
He presented the following example: An investor has $40 million, borrows $60 million more and buys a property for $100 million. Later, he sells it for $150 million. After returning the loan, the investor has made $50 million in profit, leaving aside interest and depreciation.
If the transaction is taxed as a capital gain, the government will take 20 percent of profits, or $10 million. If it’s taxed as ordinary income, at 40 percent of profits, that’s $20 million. The investor’s rate of return in the first case is 100 percent of principal, or double his money, while in the second, it’s a still-respectable-but-much-lower 75 percent.
“Real estate investors tend to be willing to push the envelope more from a tax perspective than, perhaps, other types of investors. They’re willing to run these tax risks in order to save that 20 percent on the tax,” Wolfe said.
The schemes
Consider Wolfe’s second scenario: A real estate investor buys a high-end property with the intention of holding it as an investment, with a paper trail documenting that intention. Six months later, she receives “an offer she can’t refuse” for the asset.
If she sells on the spot, she will have to pay ordinary income rates, because the investment has been held for less than a year.
But there are alternatives, said Wolfe. The investor could sign a sales contract, but set the closing date six months out.
Or, if the prospective buyer can’t wait and wants to start work on the property now, the investor could offer him a lease with an option to buy in the seventh month.
“It doesn’t come up every day, but the hotter the market is, the more often it comes up,” said Wolfe. That’s because in a hot market, there are simply more offers that investors can’t refuse.
Wolfe said he’s even heard proposals for how to claim sales of ground-up condo developments — the quintessential “dealer” activity — as capital gains.
For example, the developer, who has almost certainly owned the land for more than a year, can sell some of the units in bulk, claiming that block was originally intended as an investment. Or, he can rent units out for a period, say, two years, and then, at the time of sale, claim them as having been primarily investment properties.
The audit lottery
It’s not only the incentives that spawn schemes like this, but the vagueness of the law, explained Alan Winters, a partner at Sagal & Winters.
“It’s unfortunately an extremely muddy area. There are not generally bright-line rules to know that you’re safely on one side of the line or the other,” he said.
A tax lawyer’s job, Winters said, is to assess their clients’ plans on the legal merits and then let them decide.
“A client will come in and say, ‘Here’s the facts in this case.’ I’ll kinda look and then I’ll tell them, ‘I think you have a position; a strong position, or flip a coin, or a weak position,’” he said. “The clients are sometimes — its New York real estate, certainly, so, often – very aggressive. And they’ll say ‘I’ll take my chances.’ Or they might say I don’t want a headache, so I’ll just pay the income tax and not have to deal with the IRS.”
Not all Winters’ clients are willing to do “backflips” to get the more favorable treatment. “There are many people in New York who are aggressively pursuing this, but really, it’s the risk tolerance of the client,” he said.
The risk though, is less significant than it might appear.
[vision_pullquote style=”1″ align=””] “I see people out there doing ridiculously aggressive things. Not often, but from time to time I see it, and I shake my head. And they get away with it because of the audit lottery.” — Richard Wolfe, Fried Frank [/vision_pullquote]
In all the above cases, Wolfe said, the IRS may very well flag the investor/developer’s returns and argue that the actual closing happened when the deal was signed. In that case, the agency would issue a “notice of a proposed adjustment” requiring the investor to pay ordinary income tax on the transaction, plus interest, generally set at 3 percent above the federal funds rate for non-corporate filers, and 5 percent above for corporate.
That is, the IRS would likely flag it in the case of an audit. But audits are exceedingly rare for most filers. On the whole, only 0.9 of individual tax returns and 1.3 percent of corporate returns were audited in 2013, according to the federal agency.
Wolfe said the IRS, in determining whom to audit, seeks to maximize the amount of underpayment it catches. The best way to do that is by targeting the largest taxpayers: major corporations like General Motors. Most of New York’s real estate players, though wealthy, operate well below that level of income.”
The lack of a deterrent encourages developers and investors to sometimes push the envelope.
“I see people out there doing ridiculously aggressive things,” said Wolfe. “Not often, but from time to time I see it, and I shake my head. And they get away with it because of the audit lottery.”
Even if our imagined investors were audited, they’d have a chance to appeal within the IRS and argue for a settlement somewhere between the ordinary income and capital gains rate.
“If you’re really not too aggressive with your tax position, there’s a very good chance you’ll get a settlement,” Wolfe said. “So by taking the position, yeah, you didn’t get the whole loaf, but you got half a loaf, and that’s better than no loaf.”
The big picture
It remains unclear how widespread the practice of investors making questionable capital gains claims, but experts and industry sources told The Real Deal it was a normal course of business for many.
[vision_pullquote style=”1″ align=””] “It’s unfortunately an extremely muddy area. There are not generally bright-line rules to know that you’re safely on one side of the line or the other.”- Alan Winters, Sagal & Winters [/vision_pullquote]
“My guess is that there is widespread abuse of the election [between capital gains and ordinary income] and the deterrent factor is limited without any high profile audits,” said Jesse Keenan, research director at the Center for Urban Real Estate at Columbia University. Dealers often incorrectly seek investor status, he added.
It’s difficult to put a number on the overall tax impact. New York’s real estate players largely operate as private enterprises, meaning their tax filings are confidential. Several of the city’s major developers and investors declined to comment for this story.
Aside from capital gains, many developers and investors favor the 1031 “like-kind” exchange, which allows the deferral of ordinary income tax on profits that are rolled over into other real estate investments. These deferments can be passed from deal to deal indefinitely. If an investor dies with deferred taxes, the obligation is not passed on to heirs.
In general, real estate industry players benefit greatly from creative accounting and lax enforcement.
“If I were really smart, we wouldn’t be doing what we’re doing, working as journalists and tax lawyers,” said Wolfe. “We’re doing the stupidest thing from a tax perspective, paying ordinary income on all our earnings, no deferments. If we were really smart, we’d be real estate investors.”