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Condominium Conversions: Key Tax Planning Considerations
By David M. Cohen and Thomas C. Nice*
I. Multifamily residential project sample fact pattern:
A. Non developer/seller:
- Adjusted tax basis = $ 40 million
- Value as apartments = $60 million (based on cash flow @ 6% cap)
- Value as potential condominium project = $85 million
- Total potential gain = $45 million
- Estimate of tax on sale at capital gains rate:
- 40% depreciation recapture (30% fed + state) = $5.4 million
- 60% regular capital gain (20% fed + state) = $5.4 million
- Total $10.8 million
- Estimate of tax at ordinary income rate:
- All at 40% + state = $18.0 million
- Difference (F.I.T. at issue) ($ 7.2 million)
B. Developer/purchaser:
- Wants 20% + return to proceed with project.
- Must wait until after lenders are paid for distributions (phantom income concern – see also IVC).
- Will invest an additional $15 million to convert/improve project.
- Will sell units for $125 million on $100 million investment.
II. Planning involves negotiating a compromise among competing interests.
A. Non-developer/seller concerns:
- Preserve capital gain.
- Maximize profit.
- Participation in development profit.
- Tax deferral via “tax free” exchange.
- Minimize or eliminate transfer taxes.
- Avoid statutory purchase rights of first purchase by or for tenants.
B. Developer/purchaser concerns:
- Minimize or eliminate transfer taxes.
- Choice of development entity form.
- Develop return structure for investors.
- Timing of the purchase in the development process.
- Tax accounting issues.
- Possible combination of purchase and venture with property owner.
III. Non-developer/seller concerns.
A. Preserve capital gain: the more passive the better.
- Critical question: is the transaction a sale of property held for sale in the ordinary course of a trade or business (is the seller a “dealer”)?
- Factors to consider:
- Purpose for which property was acquired.
- Purpose for which property was held.
- Extent to which improvements were made.
- Duration of ownership.
- Ordinary business of taxpayer.
- Frequency, number, continuity of sales.
- Extent of promotion, other active efforts to solicit buyers.
B. Maximize profit: the more active the better.
- Steps are often seen as in opposition to investor status:
- Short term ownership with active improvement efforts.
- Establish a condominium regime.
- De-tenant the property through attrition or buyouts.
- Create a model apartment, as improved, upgraded.
- Take deposits from prospective purchasers.
C. Participate in the development entity.
- By contribution: a type of “reverse alchemy” turning pre-contribution capital gain into ordinary income.
- By sale:
- To a partnership or LLC: seller must own < 50% of entity capital and profit.
- To an S Corporation: Bramblett case offers greater flexibility.
- Such sale should be structured with installment note to be paid down out of unit sale proceeds.
- Practical considerations (avoid “sham transaction”):
- Arm’s length sale terms.
- Non-contingent sales price.
- Adequate security for installment obligation.
- Purchaser to be sufficiently capitalized.
D. Deferral of gain with “tax free” exchange.
- Exchange must be of “like kind” qualified property held for business or investment purpose.
- Qualified property includes real estate; excludes corporate stock, partnership or LLC interests. But see III (E).
- Holding period of the property by the seller is important (beyond 2 years generally a safe period).
E. Transfer Tax considerations.
- Virginia transfer tax is not generally a planning factor (combined Grantor and Recordation tax: $4.25/$1,000).
- Sale of real property vs. controlling equity interests:
- D.C.: tax applies in both cases, with minimal exemption.
- MD: relief still available to sales of equity. But see III(D). Other transfer tax exemptions are available using LLCs and S Corporations.
F. Tenant purchase rights.
- D.C. Rental Housing Conversion and Sale Act of 1980:
- "95-5” transaction.
- Other exempt transactions.
- Bill 16-50, currently pending.
- Montogomery County, Maryland.
IV. Developer/purchaser concerns.
A. Transfer tax considerations.
- See III(E).
- Developer may have offsetting concerns about contingent liabilities.
- Developer, unlike non-developer, may acquire partnership/LLC interests to close a “tax free” exchange.
B. Choice of development entity.
- Likely alternatives: LLC vs. S Corporation.
- S Corporation is less flexible and may not allow business deal to be struck with investors (see IV(C), but may be critical to accommodate non-developer planning (see IIIC(2)).
- In MD, use of LLC may facilitate transfer tax saving. See IVA.
C. Deal structure with investors.
- Is the non-developer an equity holder? If so, it may be appropriate to create a membership class subordinate to cash investors.
- Cash investors may be “mezzanine” lenders, or equity investors with priority returns as well as percentage of residual profit.
- Be aware of timing differences between cash flow and profit allocation. This may yield temporary “phantom income” allocated profit without cash flow.
- Consider the use of special income allocations and tax draw distributions.
- S Corporations, unlike LLCs, are limited to a single (economic) class of stockholder – may not have sufficient flexibility for a deal requiring creative financing.
D. Timing of the acquisition.
- Acquisition later in the development process offers less risk for purchaser, but may be inconsistent with non-developer’s tax planning. See IIIA.
- Who established the condominium regime?
- Who improved the units?
- Was the purchase timed to occur after tenants have been bought out (is this becoming standard practice in D.C.)? Is tenant buyout becoming a normal cost of doing business – who bears the cost?
E. Tax accounting issues.
- Deductible vs. capitalized expenses.
- Tax deferred refundable deposits vs. non-refundable deposits as taxable income.
- Long-term-construction method of accounting issues (AMT).
F. Combining a purchase with venture with non-developer.
- Useful technique if the “seller” bargains to receive back units after development.
- The venture structure may provide the seller/non-developer a result similar to “tax free” exchange.
- This technique may offer the non-developer/seller exchange benefits where the structure does not otherwise fit within the exchange rules.
*Thomas Nice is a CPA with the Reznick Group. He can be reached at thomas.nice@reznickgroup.com.
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