General Rule

All real property not liquidated upon receipt or shortly thereafter, will be deemed to be held in one of three possible ways: 1) for use in the performance of an exempt function (avoids federal UBIT on gain upon sale and may qualify for state property tax exemption as well); 2) as an investment (sales proceeds are non-taxable capital gain unless debt-financed property, but probably will not qualify for any state tax exemptions); or 3) for sale to customers in the ordinary course of business (sales proceeds are taxable as ordinary income and property is fully subject to state taxation).

Whether property is being used in the performance of an exempt function depends on the charitable purposes of an exempt organization, but will require in any event the conduct of charitable operations or activities on the property. Although, it is possible to dedicate certain property for a future charitable use in certain circumstances. In some circumstances, exempt use property may also be treated as §1231 property (property used in a trade or business), depending on the circumstances.

Property held for investment purposes will generally be all property which is not used in the performance of an organization's exempt functions or trade or business, and which is not held for sale to customers in the ordinary course of business. The rules and definitions of IRC §1221 (defining a capital asset) are assumed to apply. Thus, stock-in-trade or inventory, certain intellectual property created by the holder, accounts receivable, consumable supplies and certain types of speculations do not qualify as investment property.

Whether property is held for sale to customers in the ordinary course of business will depend on the nature and extent of an exempt organization's activities with respect to the property. General factors used to determine if property is sold in the ordinary course of business are: 1) the purpose for which the property was acquired; 2) its cost; 3) the activities of the owner in improvement and disposition of the property; 4) the extent of improvements made; 5) the proximity of the sale to the purchase; 6) the purpose for which the property was held; 7) prevailing market conditions; and 8) the frequency, continuity and size of sales.

The number, frequency, and continuity of sales generally is regarded as the most important factor, although no one factor alone is determinative. Sales activities that tend to show that property was held primarily for sale include the promotion of sales through advertising, "for sale" signs, a sales office, and employment of sales personnel.

An exempt organization may expend reasonable amounts of money to improve and subdivide real property to facilitate its liquidation without threatening the property's classification as a capital asset. However, subdivision creates an inference that the subdivided lots are held primarily for sale. Further, if the profit from the disposition is attributable to the improvements rather than an increase in the value of the real property, the character of the gain is generally regarded as ordinary income.

Separate special rules apply to depreciable realty, farm land, oil, gas, or mineral properties, and converted wetlands or erodable croplands.

Section 1237 Safe Harbor

Section 1237 deals with the question of when real property subdivided for sale may be deemed not held for sale in the ordinary course of business and instead treated as held for investment.

Principal Requirements

The principal requirements for §1237 to apply are as follows: 1) the exempt organization cannot be a dealer in real estate; 2) the exempt organization cannot be a C corporation; 3) during the year of the sale, the exempt organization cannot hold any other real property primarily for sale; 4) no substantial improvements can be made to the property by the exempt organization; and 5) the exempt organization has either held the property for 5 years or obtained it by bequest or devise.

Evidence of dealer status includes: 1) selling activities in connection with other property during the same years that the exempt organization subdivided and sold the property in issue; 2) the exempt organization's intention in prior years to hold the property primarily for sale; 3) subdivision of other property at the same time; and 4) construction of a permanent real estate office that the exempt organization could use in selling other real property.

Tacking of holding periods is permitted where appropriate. There is no holding period requirement for property acquired by devise or inheritance. Property now held by a corporation which may become a subsidiary of an exempt organization will be determined in its own right and not be affected by the rule for devises or bequests.

Improvements

The increase in the value of a lot or parcel attributable to an improvement is the difference between the value of the property with the improvement and the value the property without the improvement. Increases due to market conditions are disregarded. An increase in value of 10% or less is deemed insubstantial. Increases in excess of that amount are substantial or insubstantial depending on all the facts and circumstances.

Improvements such as the construction of buildings or hard surface roads and the installation of water, sewage, gas and electric facilities are generally considered substantial improvements. On the other hand, the construction of temporary structures and gravel access roads and surveying, filling, draining, and leveling operations are generally not considered substantial improvements.

An otherwise substantial improvement will not be treated as substantial if: (1) the exempt organization held the lot or parcel for at least ten years before its sale (regardless of whether it was inherited); 2) the improvement consists of the installation of water, sewer, or drainage facilities or the construction of roads (including hard-surfaced roads); 3) the improvement was necessary to sell the lot or parcel at the prevailing local price for similar sites; and 4) the exempt organization elects not to increase its basis in the lot or deduct the cost of the improvement.

Tax Treatment

All of the gain from the sale or exchange of the subdivided property is treated as capital gain until the taxable year in which the sixth lot is sold. For the year in which the sixth lot is sold and any subsequent year, 5% of the gross income will be treated as ordinary income. The balance of the amount realized, to the extent it exceeds the exempt organization's basis, is treated as capital gain. The exempt organization's selling expenses do not reduce the amount realized, nor are they deductible. Rather, they are allocated first to reduce the ordinary income recognized and then to reduce the capital gain recognized.

This safe harbor dovetails with the "business enterprise" definition in IRC §4943(d)(3), which permits non-passive income to the extent of 5% of gross income.

Definition of a Tract

In computing the number of lots sold by an exempt organization, a single sale of contiguous lots to a single buyer is treated as only one lot. A "tract of real property" includes either a single piece of real property or two or more pieces of real property if they were contiguous at any time while held by the exempt organization, or would be contiguous except for the interposition of a road, street, railroad, stream, or similar property. The single piece or contiguous properties need not have been conveyed by a single deed. If no sales are made for five years after the sale of at least one lot of the tract, the remainder of the tract is deemed a new tract for the purpose of counting the number of lots sold.

Final Notes

Section 1237 does not apply to the conversion of an apartment building into condominiums or to the sale of condominiums to the general public. However, this does not prevent the exempt organization from otherwise proving that the condominiums were not held primarily for sale to customers.

If an exempt organization cannot use §1237 to establish that the property was not held primarily for sale to customers, it can still use case law or other authority to negate dealer status. Further, if dealer status can be negated other than by use of §1237, none of the limitations contained in §1237 will apply even if its requirements are otherwise satisfied.