If you own raw land as an investor, you can cash in on a tax break under Section 1237 of the tax code by subdividing the tract and selling off in smaller parcels. As long as you stay within the tax law boundaries, all of your profit is treated as capital gain, taxed at a maximum tax rate of 20%.* However, if the IRS deems you to be a “dealer” for tax purposes, your real estate profits are taxed at higher ordinary income rates of up to 39.6%.
To qualify for this special capital gain treatment, you must meet the following requirements:
- You have owned the land at least five years (or acquired it by inheritance or another method).
- There have been no major improvements on the land being subdivided.
- You did not previously hold the land for sale to customers in the ordinary course of business.
- No other property is being held primarily for sale to customers in the year of the sale.
This tax break is not limited to individual investors. Under a tax law change, S corporations can also qualify for preferential capital gain treatment under the Section 1237 rules.
As long as you meet these requirements, the entire gain is treated as capital gain if you sell less than six lots from the tract. (If you sell two or more adjoining lots to the same buyer in a single sale, it only counts as the sale of one lot). However, if you sell six or more lots from the same tract, up to 5% of the gain from the sale is taxed as ordinary income (reduced by your selling expenses).
Timing is everything: When you sell five lots in a tract in the current year and another lot the next year, the five-percent rule only applies to the lot sold in the following year (and any subsequent sales of lots from the same tract). If possible, you might use this technique to reduce the tax liability from the sales of a huge tract of land.
Of course, subdividing land – rather than selling it intact – involves more than just taxes. If you go this route, you probably need to deal with local zoning boards, surveyors, land engineers and more. Consult with your real estate adviser before getting started.
*Note: The 20% 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%.