Real Estate Partnership- Ordinary vs Portfolio Income
Posted: 2-Jul-2019 8:57pm
How's it going everyone? Been lurking for a year or two and have a question I am stumped on. I am a sole practitioner so I have been running in circles in my brain and thought I may try out the board for some assistance.
Background: Client is a Real Estate fund that invests in "Land Banks" and also sees some deals throughout the entire construction process (Land purchase, construction, sale). A Land Bank for those who don't know is essentially the fund acting as the lender for land investments so large home builders can deploy their capital elsewhere. The Land Bank will purchase the land (So titled in my clients LLC) and charge an "Option Fee" on the capital balance outstanding (12 - 15%), the home builder agrees to purchase a certain # of lots each quarter until the land has 100% transferred to the home builder. The land is only held for a year or 2 and lot tracts start being sold within a few months of closing. The actual sale transaction of the lots to the home builder is always a "net zero" sale (proceeds = basis). So the only income in these entities is the option fees.
The Fund has big time investors and over $25M in capital raised. A top 8 firm does the audit and is working on the fund tax return. I connected with a college buddy who is working for the fund and they engaged me to work on some of the land banks. The top 8 firm had already started 1 of the land bank entities so I took 3 others. The Fund sets up separate LLC's for each investment project so each "Land Bank" has a separate tax return. They have a very close strategic partnership with one of the largest home builders in the country and they do most of their deals with them as joint ventures.
Anyways --- I proceed to prepare 2 of my land banks. From the start, I considered all of this income to be ordinary income. 1) Land Banking is by definition the funds trade/business. The income generated from the option contracts is over 75% of their revenue and the fund was created to manage these kind of "land bank" deals. 2) Option Fees are not interest income ---- The Tax Court has held that payments under an option are not taxable as interest, even though they are expressed as a percentage of the purchase price. Moreover, option payments do not lose their nontaxable character merely because they are not to be offset against the purchase price. Carl E. Koch
, 67 T.C. 71 .
Last week, the other firm prepares one of their land banks and proceeds to classify the option fees as Interest Income. Interest/Portfolio Income specifically excludes income derived from dealing in any property if such activity constitutes a trade or business. Is there some kind of exception for real property/land? My contact has not had a chance to ask the appropriate questions to the other firm and I am starting to stress a little so I wanted to ask the board.
My 2 main questions are:
1 - Is there some type of support that would allow the option fees to be treated as portfolio income?
2 - At the fund level (holding entity), is there a benefit to wealthy investors (millions in income per year) to receive "Portfolio Income" over Passive Ordinary Income? I cannot think of any reason but I would assume if the other firm took this position it is more beneficial?
Let me know your thoughts when you get a chance. If I wasn't clear on anything, please ask for clarification. Really appreciate everyone's help, you can only do so much tax research by yourself before you start to go crazy!
Thanks.
Background: Client is a Real Estate fund that invests in "Land Banks" and also sees some deals throughout the entire construction process (Land purchase, construction, sale). A Land Bank for those who don't know is essentially the fund acting as the lender for land investments so large home builders can deploy their capital elsewhere. The Land Bank will purchase the land (So titled in my clients LLC) and charge an "Option Fee" on the capital balance outstanding (12 - 15%), the home builder agrees to purchase a certain # of lots each quarter until the land has 100% transferred to the home builder. The land is only held for a year or 2 and lot tracts start being sold within a few months of closing. The actual sale transaction of the lots to the home builder is always a "net zero" sale (proceeds = basis). So the only income in these entities is the option fees.
The Fund has big time investors and over $25M in capital raised. A top 8 firm does the audit and is working on the fund tax return. I connected with a college buddy who is working for the fund and they engaged me to work on some of the land banks. The top 8 firm had already started 1 of the land bank entities so I took 3 others. The Fund sets up separate LLC's for each investment project so each "Land Bank" has a separate tax return. They have a very close strategic partnership with one of the largest home builders in the country and they do most of their deals with them as joint ventures.
Anyways --- I proceed to prepare 2 of my land banks. From the start, I considered all of this income to be ordinary income. 1) Land Banking is by definition the funds trade/business. The income generated from the option contracts is over 75% of their revenue and the fund was created to manage these kind of "land bank" deals. 2) Option Fees are not interest income ---- The Tax Court has held that payments under an option are not taxable as interest, even though they are expressed as a percentage of the purchase price. Moreover, option payments do not lose their nontaxable character merely because they are not to be offset against the purchase price. Carl E. Koch
, 67 T.C. 71 .
Last week, the other firm prepares one of their land banks and proceeds to classify the option fees as Interest Income. Interest/Portfolio Income specifically excludes income derived from dealing in any property if such activity constitutes a trade or business. Is there some kind of exception for real property/land? My contact has not had a chance to ask the appropriate questions to the other firm and I am starting to stress a little so I wanted to ask the board.
My 2 main questions are:
1 - Is there some type of support that would allow the option fees to be treated as portfolio income?
2 - At the fund level (holding entity), is there a benefit to wealthy investors (millions in income per year) to receive "Portfolio Income" over Passive Ordinary Income? I cannot think of any reason but I would assume if the other firm took this position it is more beneficial?
Let me know your thoughts when you get a chance. If I wasn't clear on anything, please ask for clarification. Really appreciate everyone's help, you can only do so much tax research by yourself before you start to go crazy!
Thanks.