Do you own highly appreciated land that you now want to subdivide and sell off for a big profit? If so, you could be facing an uncomfortably large tax bill.
When you subdivide the property and market the resulting lots, you’re generally considered to be a real estate dealer for federal income tax purposes, and the lots are considered inventory held for sale to customers. So your profits will be treated as high-taxed ordinary income rather than lower-taxed long-term capital gains.
Under the current rules, the maximum federal rate on ordinary income is a whopping 39.6 %. In addition, you might owe the 3.8% Medicare surtax on net investment income, and you might owe state income tax too.
It would be much better if you could instead pay lower long-term capital gains tax rates on your profits since the current maximum federal rate on long-term capital gains is 20%.
Special Taxpayer-Friendly Rule
The good news is that you can pay the lower capital gains rate 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 a real estate dealer when you subdivide property and sell the lots. Instead, your lot-selling profits are treated as lower-taxed long-term capital gains (assuming you’ve held the lots for more than one year).
Example: Let’s say you could subdivide your property and sell off the resulting lots for a gain of $2 million. Under the general rule, your subdividing and marketing activities would make you a real estate dealer in the eyes of the IRS. So your $2 million profit would probably trigger a federal income tax bill of $792,000 (the maximum 39.6% rate times your $2 million profit).
If, on the other hand, you qualify for the favorable Section 1237 exception, the maximum federal income tax bill would be only $400,000 (20% times $2 million). (These figures ignore any impact from the 3.8% Medicare surtax on net investment income or state income tax.)
Qualifying for the Exception
Here are some details on who is eligible for the Section 1237 exception:
- You generally must have owned the land for at least five years.
- You cannot have held any portion of the land for sale in the ordinary course of business (in other words, as inventory in 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 Section 1237 rules) that significantly 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.
- The Section 1237 exception 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.
While the Section 1237 exception can be very beneficial to your tax situation, do not just assume that you qualify. The eligibility rules are complicated, and this article only explains the basics. Consult with your attorney and tax adviser to make sure you can successfully clear all the hurdles. You may need to do some advance planning to lock in your eligibility.