Iowa Capital Gain Break: how it works when you rent property to your business

October 5th, 2012 by Joe Kristan

 

Flickr image by John Snape used under Creative Commons license

The Iowa Department of Revenue has released a Policy Letter illustrating how Iowa’s “10 and 10″ capital gain exclusion works when you own business real estate in one entity and the operating business in another.  The rule allows taxpayers to exclude capital gain from Iowa income on the sale of business real estate* held for ten years and used in a business in which the also has taxpayer “materially participated” in for ten years.The facts from the policy letter (my emphasis):

Both scenarios involve a taxpayer who is a nonresident of Iowa.  This taxpayer owns an interest in his business, an S corporation, for more than ten years.  The taxpayer has been a material participant in the S corporation for more than ten years.  The S corporation does business solely within Iowa.

Under the first scenario, the S corporation sells real estate in a sale/leaseback transaction.  The real estate has been owned by the S corporation for more than ten years.

In the second scenario, the taxpayer owns a controlling interest in a limited partnership.  The partnership has rented Iowa real estate to the S corporation for more than ten years.

You are asking if the capital gain from the sale of the real estate in both scenarios would qualify for the Iowa capital gains exclusion.

Iowa follows the federal “passive loss” Section 469 rules in defining “material participation.”  The letter says that the gain in both cases qualify for the exclusion — even though the taxpayer is an Iowa non-resident, and even though in the second scenario the real estate isn’t owned in the same entity in which the material participation occurs:

Similarly, in regard to the second scenario, as long as the taxpayer materially participated in the operations of the partnership by meeting one of the section 469(h) tests for the ten years prior to the date of the sale, the taxpayer is eligible to claim the Iowa capital gain deduction for this0`1w   sale.  The fact that the federal passive loss rules deem net income from self-rental as non-passive income does add additional support for this conclusion. 

The letter comes to the correct conclusion.  Non-residents can qualify for the Iowa capital gain exclusion, and real estate used in the business can qualify even when the real estate is owned in a separate entity by the participant.

*It also allows taxpayers to exclude gains on the sale of an entire business when the 10-and-10 standards are met.  More here.

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