Real Estate Partnership- Ordinary vs Portfolio Income

Technical topics regarding tax preparation.
#21
Dennis2  
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So many things we don't know here. Does the land bank ever act as an owner paying insurance and real estate taxes or is the option fee adjusted in anticipation of those expenses? Does it have active management that does something besides collect checks?

I guess my problem with rejecting the big firm opinion is that I don't see a business purpose for the structure. All the convolutions seem to deal with taxation and income recognition. Neither do I see enough of a tax benefit to worry about this being called a shelter.

Hopefully the big firm will provide us with an answer.
 

#22
Chay  
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Dennis2 wrote:I guess my problem with rejecting the big firm opinion is that I don't see a business purpose for the structure. All the convolutions seem to deal with taxation and income recognition.

Your argument is that a situation of the bank holding property and then selling it should be treated identically to a situation of the bank lending money and then collecting payment later. You would have us believe that because it makes no difference to the two parties which way they structure it, it should also make no difference for tax purposes.

But your argument has a problem: you stopped short of supporting your proposed treatment of both factual situations as a loan and not a deferred sale arrangement. Why shouldn't we treat both situations as though the bank continues to hold title to the property until the money has been fully transferred as agreed?

There is also a problem with your premise that identical outcomes are treated identically for tax purposes. Let's say I agree to buy your car on June 30th, 2020. Until then, neither of us is going to be using it because [insert reason here]. But I happen to itemize my deductions while you take the standard, so you go ahead and sign over the title to me now in advance of my payment. I pay the property taxes, get the deduction in 2019, and you reduce the purchase price slightly in exchange.

On June 30th, if I pay as agreed, the outcome may well be identical. So, using your logic, we need to ignore the fact pattern that actually played out in 2019 and pretend you still held title to the car. But the problem with that is we don't know if I'm going to pay as agreed. In your world, on April 15th, when taxes are due, we have no way of knowing what transactions occurred in 2019 "in substance" until all obligations in respect of those transactions are resolved one way or another.

In reality, the substance of the two situations is quite different. The person who bears the benefits and burdens of ownership has changed, and there is a substantial economic effect to this change. What if the car causes property damage? Who is liable? Who is liable for the property tax if I don't pay it? These are real-world problems resolved under state property laws, which don't care in the slightest for how a transaction is treated for federal tax purposes. So what if structuring things this way has a beneficial tax effect? If I mail a check on December 31st and you get it on January 2nd, there's a deferral of your income relative to my expense. Will you use your identical outcome doctrine and recognize the income on December 31st because that's what would have happened had I used a credit card?
 

#23
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"Optioner" or "optionor"? Vote now, vote often!
 

#24
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OP's facts seem to me to be way more like a loan with the land bank holding title as security and restricting development until payment is made for specific lots.

Are you saying the Option Agreement should not be respected as such? It sounds like it and it sounds like Dennis would agree…
plus the risk of having to sell the land again to recover their investment.

But isn’t that part the nature of an option payment? (And I did note your use of the word “again,” implying the transaction should be cast as a sale). Doesn’t the Land Bank’s risk arise if the option isn’t exercised? And about that specific risk, what is it? It seems there’s a risk that the land value decreases. Whether or not that happens doesn’t really matter, it’s just a risk. The other part of this, as I see it, is that if the value stays flat, the Land Bank is precluded from selling the land to another buyer during the option period. If the value stays flat, that gets to your other point about compensatio for the Land Bank’s cost of money. And part of the overall holding period risk is that the Land Bank will incur holding costs, so perhaps part of the 12%-15% option fee is more or less a reimbursement for that. I can also see the Land Bank wondering about a possible sharp increase in value. Wouldn’t the option payment partially represent Land Bank’s desire to share in that appreciation to some degree? That is, it mitigates the risk that the Land Bank completely loses out on appreciation.

Like I said, there are much splitting of the hair that could be done here. But doesn’t it come down to this: Whether or not we have a valid option agreement? If we have that, then it shouldn’t matter if the agreement states the option payments won’t be credited at closing. They simply would be in practice. They would be added to the purchase price upon option excerise (or brought into income if the option lapses unexercised). If we have a valid option agreement, isn’t it implied that there is a real risk to the Land Bank?

It seems that if we have a valid option agreement, no hair splitting takes place. Even if part of the option fee is for the forbearance of money, it is not cast as such. Now if we have a sale, then we get into hair splitting. But it might be easy. Either the full option payment represents interest or we impute it somehow. In Koch, a hair splitting argument wasn’t raised by the IRS. The IRS just wanted to treat the full option payments as interest (at least this was one of their arguments).

Given that the “buyer” might not exercise the option, on what grounds could the form of the transaction be attacked based on a substance that feels like indebtedness? Would one factor be whehter or not the developer always exercises his options? To me, the fact that we have a special purpose Land Bank entity here means we should not be permitted to see what this particular developer has done with other Land Banks in the past. And it also seems that to level charge of a pre-arranged deal (i.e. a sale) because the developer always exercises his option would involve a whole lot of hindsight and/or a whole lot of prognosticating.
 

#25
Dennis2  
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I am only saying that we are told the business of the land bank is lending and that regardless of structure, a big eight (?) firm characterizes the income as portfolio. I am not saying that you couldn't structure a transaction similar to this to produce ordinary income just that I see no reason to dispute the big firm based on the facts presented.
 

#26
Dennis2  
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idle curiosity. sale for 1 mil and simultaneous purchase of option for 100K (which must be mandatory) is somehow different than sale for 900K with option rights reserved?
 

#27
Chay  
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Hopefully the OP will make it back to this thread eventually and clarify some of the facts so that things point one way or another.

The 900K transaction you propose sounds like it might be substantially the same as the 1M transaction. The fair market value of the property is 1M, but the seller receives 900K and option rights instead. The seller takes the option rights into income as gross proceeds. Meanwhile, the buyer records 100K received on the option, which is equal to the FMV of the option, 100K, minus the option's basis of zero. The tax treatment of that 100K would of course depend.
 

#28
Nilodop  
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In post #1 the OP has raised whether, even if the option fee is treated as interest, it's not portfolio income if it's derived in the ordinary course of a trade or business. Did the big firm consider this? Did we?
 

#29
Chay  
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It had crossed my mind that even if the option fee were interest, it would be considered derived in the ordinary course of a trade or business under 1.469-2T(c)(3)(ii)(A) and therefore not portfolio income. Interestingly, net passive income from the activity would then be reclassified as nonpassive in any event under 1.469-2T(f)(4)(i).

I didn't bring that up until now because it didn't seem relevant in a scenario which I believe clearly does not involve lending or interest income. But I guess it's relevant since there seem to be a few loyalists out there who hesitate to question the wisdom of Big Firm. Even if Big Firm is right that it's interest income, they're still reporting it wrong. Whatever wisdom they have over there, it clearly isn't useful in preparing a tax return for a land bank.
 

#30
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Hey everyone, I appreciate you all taking the time to give feedback. All very helpful.

A lot of posts so I am going to come in with a general update/response.

No update from the big firm, as usual they are taking their sweet time to finalize their engagement. Still discussing the reporting treatment with colleagues. One thing to note here is the fact that the land bank LLC has taken out debt to help fund the land purchase. As stated earlier, the main goals for the home builder are to 1) retain more cash on hand to pursue other projects. 2) keep any debts off their books

I do want to state that the Lot Purchase Agreement does not state there is an enforceable right or action. The buyer entity (home builder) pays a 10% deposit up front when the land is initially purchased. Should the agreement terminate, the 10% would be retained as Ordinary income. Should the agreement complete, the 10% is returned with the final lot sales.

I believe Koch is a very relatable case but I think it all boils down to this:
An optionor's receipt of consideration for granting an option generally is treated as a nontaxable "open" transaction if the consideration is applicable against the purchase price upon exercise of the option. The transaction normally remains open until the option is either exercised or expires, at which time the character of the income realized can be ascertained. E.g., Dill Co., 33 T.C. 196 , aff'd, 294 F.2d 291 .However, if the optionor can only have ordinary income regardless of whether the option is exercised or forfeited, the consideration for the option is taxed in the year of receipt. Comm'r v. Pickard, 401 F.2d 615 .

That final sentence/case leads me to believe this is ordinary income, not interest income. The option fee collections can only be considered ordinary income because the LLC is in the business of earning option fees and has proven such through their multiple business dealings in Land Banks, their private placement memorandum, pitchbooks, etc.

Again, I really appreciate all the feedback. I was at the beach for the weekend so took some time away from my tax world.
 

#31
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That final sentence/case leads me to believe this is ordinary income, not interest income.


First of all, interest income is ordinary income.

And as to that final sentence, it seems a bit wishy washy to me. It seems like that rule might apply only if we’re talking about a zero-basis “asset.”

And what does this mean:

Should the agreement complete, the 10% is returned with the final lot sales.


Finally, what is the sequence of events here? Who does the Land Bank acquire the lots from – is it the same people that later pay the option fee to the land bank?

It sounds like it’s a situation where we have a big Home Builder, who gets some developer to clear the land (who might or might not be related to the Home Builder), put in utilities and subdivide, pursuant to the Home Builder’s specifications. And then, instead of the Home Builder acquiring the lots from the developer, the Home Builder causes Land Bank to acquire the lots.
 

#32
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Sorry, Jeff. Late night....Meant to type "Portfolio Income".

Optioner (Land Bank) can only have ordinary income regardless of whether option is forfeited or exercised since they are considered to be in the trade/business of these land banks.

The 10% I reference is the "Deposit" made by the optionee when the agreement is executed. Treated as a capital contribution on the land banks books. This is held until the end of the agreement and paid back as a return of capital once the lots are 100% transferred.

The lank bank entity acquires the lots from an unrelated party. The home builder has the resources and teams in place to research and do due diligence on potential property acquisitions. Once a property is identified, the land bank puts together the funds to purchase the land. Expected development costs are budgeted for and estimated up front, the home builder (optionee) has rights to oversee and direct any development work.
 

#33
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Optioner (Land Bank) can only have ordinary income regardless of whether option is forfeited or exercised since they are considered to be in the trade/business of these land banks.


Yeah, but you really don’t know what that amount of net gain is. You would only know the amount of net gain if you had a zero basis asset. (But even then, with real property, there will be expenses of sale). In which case, it boils down to timing.

The 10% I reference is the "Deposit" made by the optionee when the agreement is executed. Treated as a capital contribution on the land banks books. This is held until the end of the agreement and paid back as a return of capital once the lots are 100% transferred.


I still don’t get it. Is this the option payment? And a temporary credit to capital is no different than a temporary credit to a liability. At least I think you’re saying that, either way, this “deposit” won’t remain as “capital” at the end of the day.

And has the thought occurred to you that Big Firm doesn’t disagree with you, but is just passing things thru as “Interest Income” because if they do otherwise, and pass-thru on the “Ordinary Income” line, there’s a high likelihood that the passive investors will treat such amount as passive income (absent K1 disclosures, which they may or may not read)?
 

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