Roll-Over the Sale Gains from your Converted Condo Units and Defer Paying your Tax Bill.

By Stephen A. Wayner, Esq., CES, Bayview Financial

The Economics of a Condo Conversion. Why convert your apartment units into condominiums? Several economic reasons are making it more lucrative to convert units into condominiums, including: (1) the escalating sales prices of the past few years; (2) developers paying substantial premiums to acquire and transform both large and small rental properties into condos; (3) apartment owners finding their apartment units are worth much more if divided and sold as condos, rather than marketed as a single apartment complex; (4) rents falling behind the increasing sales prices for the apartment units in many parts of the U.S.; and (5) the existence of many more potential unit buyers than buyers of entire buildings. Some of the leading regional markets for conversions are those in resort areas and in growing retirement areas, as the baby-boom population continues to age and increase their leisure options.

How is it Done? The mechanics are relatively simple: First, the investor or developer purchases the property, or the existing landlord of the apartments makes the decision to convert and sell the units on their own behalf. Then the building owner/developer obtains the necessary approvals to sell individual condo units from the municipality in which the project is located. Usually, certain improvements will be required so that each individual unit can be operated as a separate unit, rather than as one part of a larger operation. With permits and improvements in hand, the owner/developer can begin to sell the units.

How is it Taxed? The condo developer or building owner normally wants to receive capital gains treatment on each individual unit. Capital gains are presently taxed at a 15% federal tax rate, plus the taxpayer’s state tax rate, which vary from zero to 11%. However, in the case of real estate that has been depreciated, some or all of the depreciation is taxed as "depreciation recapture", which is generally at a 25% federal tax rate. Finally, for sales of property that do not qualify for long-term capital gains, the maximum federal tax rate is 35%. In high tax states, the combined effective tax rate can approach 46% on the taxpayer’s gain on his or her real estate.

How can I Avoid or Defer Paying the Tax? Tax deferred exchanges under Internal Revenue Code Section 1031 permit the condominium seller to delay paying any tax on the sale of his property until he or she ultimately sells his "replacement property", rather than at the time the converted units are sold. Replacement property can consist of raw land, other apartment buildings, commercial buildings, and even properties that are under a long term lease that requires the tenant to pay all of the repairs, maintenance, taxes, interest or other expenses commonly charged to owners of the property. You must carefully plan and structure your transaction in order to qualify to rollover your federal and state income taxes on your gain from the sale of a converted condominium. First the property must have been held for a "reasonable time". What exactly constitutes a "reasonable time" is a question of fact, but generally it should be held at least more than a year and one day. Second, the condominium seller must not be considered a "dealer" in apartment units. If he is considered a dealer, then his gains are taxed similar to sales of inventory (generally at the highest tax rate) and his sales are not eligible for tax deferral. To put it in plain terms, at the time of acquisition, the owner must "intend" to hold the property as an investor, not a dealer.

Establishing Intent. The test as to whether an exchange will be classified as made by a dealer or alternatively as an investor, revolves around the taxpayer’s intent at the time of the exchange. Sometimes a taxpayer changes his intent during the period that he or she holds the property prior to the exchange. Determining the taxpayer’s intent is a question of fact, and therefore all of the facts and circumstances involved in the transaction are considered in determining the taxpayer’s intent.

Too Much Development or Sales Activity? Existing apartment owners or non-professional investors whose activities begin to resemble those of traditional dealers in real estate can be at risk of classification as developers if they begin to act like developers. The following activities are some of the many that have been considered by courts to determine whether the seller is classified as a dealer or whether he is entitled to investor status: (1) the original intent of the taxpayer when he purchased the property; (2) the length of time that the property was held; (3) whether the taxpayer has engaged in developer-dealer activities in the past; (4) the use to which the property was placed while it was held by the taxpayer; (5) whether a change of circumstances has occurred with respect to the property or the taxpayer’s economic or personal situation; (6) the extent of improvements on the property, and the time that such improvements were implemented; (7) whether the taxpayer has entered into a joint venture or similar agreement with a developer-dealer; (8) whether the property was leased to a tenant, and the length and terms of such lease; (9) whether the replacement property is disposed of, divided, or the taxpayer otherwise demonstrates that his or her intent in acquiring the replacement property is for purposes other than investment or business use.

The following table illustrates these principles:

Evidence for Dealer/Developer Treatment	Evidence for Investor Treatment
The taxpayer classifies the investment on his books and records as inventory, work or construction-in-progress, or fails to claim depreciation on the property.	The taxpayer consistently treats the property on his books, records and income tax returns as investment or business use property.
The property is developed, subdivided or sold quickly after its acquisition.	The property is held for a lengthy time, used by the taxpayer as investment or business property, or is inherited by the taxpayer.
The taxpayer has not had a change in circumstances that would motivate an ordinary person to dispose of or develop the property.	The taxpayer’s circumstances have changed. Unexpected financial pressures, being required to move and thus not being able to manage the property, death of the taxpayer or the property manager, zoning or other changes not instituted by the taxpayer, or the loss of a significant tenant could all be considered relevant to the taxpayer’s motive in conducting the exchange.
The taxpayer has made substantial improvements to the property in expectation of subdividing the property.	The property required little improvement in order to subdivide and sell, the improvements were made at a time the selling price is at fair market value or is based its appraised value at the time of purchase.
The taxpayer enters into a joint venture, partnership, or similar agreement with a developer or dealer that provides that the developer share the profits with the taxpayer or that the risk of success or failure is shared by both parties.	The taxpayer subdivides and develops the property himself, hires an outside party to construct improvements, or the agreements that the control the development and sale of the property pay the taxpayer a fixed fee for each unit sold, that is not contingent on profits from the venture, or the sales price of the units.
The units are not rented during the term that the property has been held, or the leases have been in effect for a brief time period.	The units have been rented by its tenants for a significant time period, or have been offered to the existing tenants under a right of first refusal or similar agreement.
The replacement property is subdivided and sold quickly, or the taxpayer indicates that he or she purchased the replacement property with the intent of selling the property as units.	The taxpayer maintains a continuity of interest in the replacement property, holding it for a substantial time period for investment or business purposes, or purchases replacement property that is of a nature not conducive to subdivision or development

Finally, the frequency of sales is important. Too many conversions and sales make an investor look like a developer or dealer. Each of these factors would likely be weighed by a court, if the transaction is challenged by the Internal Revenue Service. No one factor is determinative, but by the same token, "passing" a certain number of these tests will not guarantee the desired tax treatment. Any activities that imply the property was not held with the intent of investment or business use, such as resembling a developer or dealer, make it more likely that the property will not qualify for rollover-deferral treatment under Code Section 1031. Care should be taken that the taxpayer gives no indication, whether written or oral, that he or she intended to buy the property and later sell off individual units, no matter how far off in the future such sales may occur.