If you’ve held on to a parcel of land that has significantly increased in value, now may feel like the perfect time to sell. Whether it’s located in a growing area or is ready for development, realizing the gains can be financially rewarding, but it can also trigger a hefty tax bill if not approached strategically.

When you subdivide and develop the land yourself, the IRS may classify you as a real estate dealer or developer. In that case, the full gain, including any appreciation of land before development, may be taxed at ordinary income rates as high as 37%. Fortunately, there’s a way to potentially reduce your tax exposure. With the right planning, you can preserve long-term capital gains treatment on the appreciation of land that occurred before development, and reserve ordinary income treatment for profits generated from active development and marketing.

Key Takeaways

  • Appreciation of land may qualify for long-term capital gains treatment when the property has been held as an investment and the transaction is properly structured.
  • Development profits are generally taxed separately as ordinary income.
  • An S corporation may help separate pre-development appreciation from development income in appropriate circumstances.
  • Entity selection can significantly affect the tax outcome.
  • Professional tax planning before development begins is essential.

Using Entity Structure to Minimize Tax Impact

The goal is to separate the economic gain from your original land investment from the income generated through subsequent development. This approach requires a carefully executed entity strategy, usually involving the use of an S corporation.

Here’s how it works:

Step 1: Form an S Corporation for the Development Work

Create an S corporation that will be responsible for the development and sale of the property. If you currently own the land personally, you can establish the S corporation and hold all shares yourself. If the land is owned through a partnership or multi-member LLC, all members can form the S corporation together and receive shares based on their ownership percentages.

Step 2: Sell the Land to the S Corporation

Next, sell the land to your newly formed S corporation at its current fair market value. This transaction allows you to capture the appreciation of land as a long-term capital gain, assuming you’ve owned the property for more than one year and held it for investment purposes. Structuring the sale with an installment note is common, enabling the S corporation to pay for the land over time using proceeds from future parcel sales.

This step allows for the initial appreciation on the land to be taxed at preferential long term capital gain rates of up to 20%, plus the 3.8% net investment income tax where applicable rather than being taxed at higher ordinary income rates.

Step 3: Develop and Sell the Property

The S corporation can now proceed with subdividing, improving, and marketing the property. Any profits generated by the S corporation from this development activity will be considered ordinary income and flow through to you as the shareholder. While these profits may be taxed at higher rates, the blended effective rate on your total gain can still be significantly lower because the original appreciation of land was taxed at capital gains rates.

Real-World Example

Imagine you purchased land for $500,000 and it’s now worth $2.5 million before any improvements. That $2 million increase reflects appreciation of land over time. Selling the land to your S corporation locks in that gain as a long-term capital gain. Let’s say the development generates another $1 million in profit post-sale.

With proper planning:

  • $2 million is taxed at up to 23.8% = $476,000
  • $1 million is taxed at 37% = 370,000
  • Total tax: 846,000

Without planning, the full $3 million could be taxed at 37%, totaling $1,110,000 resulting in about $264,000 in additional federal income tax.

Why the Entity Type Matters

It’s critical that the development activity be conducted through an S corporation, not a partnership or LLC taxed as a partnership. Under IRS rules, selling land to a controlled partnership (or LLC) may recharacterize the entire gain as ordinary income, negating the benefits of your planning.

Also avoid using a C corporation, as this structure introduces the risk of double taxation when profits are distributed.

Final Thoughts

By understanding how the appreciation of land can be segmented from development gains, landowners can create a more favorable tax outcome. This strategy isn’t one-size-fits-all, so it’s essential to work with a knowledgeable tax advisor to confirm that your specific circumstances qualify.

At Maxwell Locke & Ritter, our tax professionals help landowners, developers, and investors structure deals that align with their long-term goals. Reach out to our team to explore how we can support your next transaction.