Real estate development from a tax perspective

Case study

Facts

A. is married, has two children and lives with his family in the municipality of Eschenbach in the Canton of Lucerne. A. also owns his own painting company, which he also operates in Eschenbach. The company generates an average profit of CHF 80,000 per year.

A few years ago, A. inherited real estate from his parents in the same municipality, which he would like to build over in the next few years. The current market value of the undeveloped real estate amounts to CHF 1 million. In the inheritance, the cantonal real estate gains tax was deferred. The relevant investment value according to the Real Estate Gains Tax Act is CHF 0.5 million, the holding period of Real Estate relevant for the calculation of the real estate gains tax is 15 years.

A. plans to build two apartment buildings with 4 x 3.5 room apartments each in condominium ownership on the properties. A. expects sales proceeds of CHF 1 million per apartment. The construction costs are estimated at approximately CHF 6 million.

Question

Based on these facts, the question arises as to whether it might be worthwhile for A. to carry out the construction or sale of the superstructure via a newly established corporation or whether it would be better for him to construct or sell the properties privately.

Tax risks

The sale of a property from private assets to a third party is subject to cantonal real estate gains tax. In contrast, the profit from the sale of a property from private assets is tax-exempt under direct federal tax and is also not subject to social security contributions of around 10%.

However, the trading of real estate by private individuals entails considerable tax risks. This applies in particular if the sale is not a simple opportunity sale, but a larger project with prior project development or project planning. The main risk is that the tax authorities will regard the development of the property and thus also the sale as a commercial activity. This results in a higher tax burden, because the profit is then also subject to direct federal tax and social security contributions.

According to Jurisprudence of the Federal Supreme Court, such a so-called "commercial real estate trade" exists if the trade in real estate goes beyond the scope of ordinary asset management and the intention is to generate income from the scheduled purchase and sale of real estate. According to the Federal Supreme Court, a gainful activity is deemed to exist in particular if the taxpayer engages in real estate trading as his main occupation or in close connection with his main occupation as a secondary occupation. According to Jurisprudence , however, a person can also be classified as a professional real estate trader if he or she only occasionally or sporadically buys and sells real estate. As soon as a person liable to tax makes an effort, like a part-time self-employed person, to exploit the development of the real estate market in order to make a profit, a gainful activity may already be deemed to exist in the individual case.

In the present case, taking into account the applicable Jurisprudence , A. would very likely be classified as a commercial real estate trader in the tax sense, as he is only pushing the development of Real Estate with a view to achieving high sales proceeds and intends to do so systematically and according to plan (i.e. "professionally").

Tax optimization strategy

In order not to be classified as a commercial real estate trader, it is advisable to transfer the Real Estate into a newly established corporation before implementing the plans. The transaction is tax-exempt at the level of direct federal tax, and at the level of the Canton/municipality, real estate gains tax is only charged on the difference between the investment costs and the market value prior to the transfer. Social security contributions are not levied. However, the transaction and the values as well as the qualification of the transfer as a private capital gain must in any case be discussed in advance with the tax authorities by means of a tax ruling.

In the present facts, A. would accordingly transfer the inherited Real Estate into a self-held and newly founded company prior to the project phase. Since the real estate is now no longer held privately by A., he himself can no longer be classified as a professional real estate trader.

The calculation of the real estate gains tax at the cantonal/municipal level is based on the difference between the investment costs and the market value of the real estate before the conversion. Based on the case study, the difference subject to real estate gains tax is CHF 0.5 million (CHF 1 million / CHF 0.5 million).

For income and withholding tax purposes, capital contribution reserves may additionally be booked at the level of the company to the extent of the fair market value of CHF 1 million. Capital contribution reserves can be distributed free of income and withholding tax as far as they have been confirmed by the FTA. This allows for a tax deferral on the subsequent repatriation of profits.

Calculation example

The following numerical example illustrates how the tax consequences differ in the respective constellations, i.e. development without transfer to a corporation and with prior transfer to a corporation. It should be noted in particular that the case study is based on the situation in the Canton of Lucerne and thus on the tax rates and practice in the Canton of Lucerne. With regard to other Cantons, the practice and legislation may lead to different results.

Variant 1: independent part-time real estate trade

Variant 2: Transfer to Immo-AG at fair value

Conclusion

If one compares the two variants with each other, it is not difficult to see that considerable taxes and duties of around CHF 60,000 can be saved in the variant with the transfer to a corporation. It should also be noted that the tax burden to be paid immediately can be considerably reduced again if the profit repatriation to the private individual is carried out by means of distributions from capital contribution reserves.

However, the variant only works if the transfer is planned with lead time and discussed in advance with the tax authorities. It should also be noted that the numerical examples are based on the legal principles in the Canton of Lucerne and that the tax advantages or disadvantages of the respective variant may differ depending on the Canton and the initial situation. In addition, it must be noted that in the case of transfer of the properties to a corporation and the subsequent sale of the properties, notary and land registry fees as well as transfer of ownership costs are incurred twice, which would only be incurred once in the case of a private sale.

If you inherit real estate or acquire it continuously over the years through private assets and would like to sell or develop it at a later date, it makes sense to start tax planning early and thus avoid unpleasant surprises with regard to the tax burden.