Do you own appreciated land that you want to subdivide and sell off for a profit? If so, you could be facing a large tax bill.
Why? Because when you subdivide property and market the resulting lots, you’re generally considered to be a real estate “dealer” for tax purposes. The subdivided lots are considered your inventory. Therefore, the profits are taxed as ordinary income at regular marginal rates, which can be as high as 39.6 percent, plus any state income tax.
It would be much better if you could instead pay long-term capital gains rates on your profits. The current maximum federal rate on long-term gains is 20 percent. The 20-percent rate only affects:
- Singles with taxable income above $400,000;
- Married joint-filing couples with income above $450,000;
- Heads of households with income above $425,000; and
- Married individuals who file separate returns with income above $225,000.
Capital gains on investments held less than a year are short-term capital gains and taxed at ordinary income tax rates of 10, 15, 25, 28, 33, 35, or 39.6 percent.
The good news is that you can pay the lower capital gains rates if you qualify for a special taxpayer-friendly exception under Section 1237 of the Internal Revenue Code. When the exception applies, you’re not considered to be a real estate dealer when you subdivide the property and market the resulting lots. Instead, your lot-selling profits are treated as long-term capital gains and your tax bill is greatly reduced.
Let’s say you could subdivide your property and sell it off in lots for a total gain of $1 million. Under the general rule, your subdividing and marketing activities make you a real estate dealer in the eyes of the IRS. So, your $1 million profit would probably trigger a federal income tax bill of about $396,000 (39.6 percent maximum rate times $1 million profit). But, if you qualify for the favorable Section 1237 exception, the federal income tax would be only $200,000, which is 20 percent maximum rate times $1 million profit.
Qualifying for Lower-Tax Treatment Under Section 1237
Here are some additional details on who is eligible for the tax-saving Section 1237 exception:
- As the seller, you qualify for favorable Section 1237 treatment only if your activities (or lack thereof) related to any other real estate holdings indicate you are not a dealer in real estate.
- C corporation sellers generally don’t qualify for the Section 1237 exception. However, it is potentially available for land you own individually or jointly and land you own indirectly via a partnership, an LLC treated as a partnership for federal tax purposes, or an S corporation.
- You generally must own the land for at least five years, unless it was inherited.
- The land must be a “tract of real property,” as defined by the applicable tax rules.
- You cannot have held any portion of the land for sale in the ordinary course of business (in other words, as inventory for the business of being a real estate dealer). Similarly, you cannot hold any other real property for sale in the ordinary course of business.
- You cannot have made “substantial improvements” (as defined by the applicable tax rules) that “substantially enhance” the value of the lots that are sold, nor can any such improvements be made pursuant to a contract for sale between you and the buyer.
If you meet these requirements, you qualify for low-taxed capital gain. However, if you sell six or more lots from the same tract, up to 5 percent of the gain from the sale is taxed as ordinary income (less selling expenses).
For purposes of applying these rules, you are considered to be the owner of other real estate if you own it jointly with another person or entity or if you own it indirectly through a partnership or LLC. However, you are generally not considered to be the owner of other real estate owned by family members, estates, trusts, or corporations.
Important: Don’t assume you qualify for the favorable Section 1237 exception. The eligibility rules are complicated and this article only explains the basics. Consult with us to make sure you can successfully clear all the hurdles. You may need to do some advance planning to lock in your eligibility.