Do you own land that you want to develop and then resell? Here’s a way to pay a lower tax bill
Suppose you own vacant land. Like other real estate, it has appreciated a lot over the past few years and you are ready to cash in. Or you may have a piece of land that you want to subdivide into lots, develop them and sell them for hopefully an equal price. bigger profit. Either way, you will have to pay taxes. Here’s what to expect.
The simple scenario: you sell vacant land that was held for investment purposes
If you have owned the lots for more than a year, you will have to pay federal capital gains tax. The maximum long-term capital gains (LTCG) rate is 20%. But you will only owe this rate on the lesser of: (1) your net LTCG or (2) the excess of your taxable income, including any net LTCG, over the applicable threshold.
For 2022, the thresholds are $517,200 if you are a married joint filer, $459,750 if you are a single filer, or $488,500 if you are using head of household status.
Example 1: You are a joint filer with taxable income of $750,000 in 2022 consisting of an LTCG of $500,000 from the sale of your appreciated lots and $250,000 of taxable income from other sources after allowable deductions. The excess of your taxable income over the applicable threshold is $232,800 ($750,000 – $517,200). This LTCG amount of $500,000 is taxed at the maximum rate of 20%. The remaining $267,200 ($500,000 – $232,800) is taxed at “only” 15%. You will also owe 3.8% net investment income tax (NIIT) on all or part of your LTCG (probably all of it), and you may also owe state income tax , depending on where you live.
Example 2: You are a joint filer with taxable income of $900,000 in 2022 consisting of an LTCG of $350,000 from the sale of appreciated lots and $550,000 of taxable income from other sources after allowable deductions. Since your taxable income before any LTCG exceeds the applicable threshold of $517,200, the entire LTCG of $350,000 is taxed at the maximum rate of 20%. You will also owe the 3.8% NIIT on some or all of your LTCG (probably all of it), and you may also owe state income tax. It’s going to be a big tax hit, but you probably won’t get much sympathy from your friends, neighbors and acquaintances.
Example 3: You are a single filer with taxable income of $400,000 in 2022 consisting of an LTCG of $200,000 from the sale of appreciated lots and $200,000 of income from other sources after allowable deductions. Since your taxable income including LTCG does not exceed the applicable threshold of $459,750, the entire LTCG of $200,000 is taxed at “only” 15%. You will also owe the 3.8% NIIT on all or part of your LTCG, and you may also owe state income tax. But at least you dodged the 20% bullet.
The complicated scenario: you intend to develop a plot and then sell
Here’s the catch in this scenario: Federal income tax rules generally treat a real estate developer as a real estate “dealer”. If you are classified as a concessionaire, your profit from the development and sale of land is considered profit from the sale of “inventory”. This means that the entire profit – including part of any appreciation in the value of the land before the development – will be heavily taxed ordinary income rather than less taxed LTCG. Under current rules, the top federal rate on an individual’s ordinary income is 37%. You may also owe 3.8% NIIT and state income tax. So your combined tax rate could be 50% or more. Yeah.
It would be much better if you could arrange to pay lower LTCG tax rates on at least a portion of the profits. The current maximum federal rate on LTCG is “only” 20%. If you also owe the NIIT of 3.8%, the combined maximum federal rate is “only” 23.8%. This is much better than the maximum combined federal rate of 40.8% (37% + 3.8%) on ordinary earnings recognized by a real estate “dealer”.
An S Corporation development entity to the rescue
Fortunately, there is a strategy that allows for favorable LTCG tax treatment for any appreciation in value of your land prior to development. This assumes you held it for investment purposes rather than as an established real estate broker. Understand this: even with this strategy, any profit attributable to subdivision, development and marketing activities will still be heavily taxed ordinary income, as you will be treated as a “concessionaire” for this part of the process. But if you manage to “only” pay a 23.8% federal income tax rate on most of your big profit (the pre-development appreciation part), that’s something to celebrate. .
Example 4: The appreciation in value of your land before development is $3 million. If you use the S Corporation development entity strategy explained below, that portion of the profit will be taxed at a federal rate not exceeding 23.8% (the maximum federal rate of 20% on LTCG plus 3, additional 8% for NIIT) under the current tax regime. Suppose you expect to reap an additional $2 million in profit from development and marketing activities. This portion will be taxed at the ordinary federal income tax rate, which can be as high as 40.8% (37% plus 3.8% for NIIT) under the current tax system.
With this dual tax treatment, the maximum federal income tax is “only” $1,530,000 [(23.8% x $3 million) + (40.8% x $2 million)]. Without any prior planning, the entire $5 million profit would likely be taxed at the maximum ordinary income rate of 40.8%, resulting in a much larger impact of $2,040,000 on your portfolio. Which would you rather pay: $1,530,000 or $2,040,000?
With the previous background in mind, here is the exercise to pay a smaller tax bill on the profit from your land development business.
Step 1: Establish S Corporation as a Development Entity
If you, as an individual, are the sole owner of the valued land, you can create a new S corporation solely owned by you to operate as a development entity. If you own the land through a partnership (or through an LLC treated as a partnership for tax purposes), you and the other co-owners can form the S corporation and receive shares of the corporation in proportion to your holdings. .
Step 2: Sell the land to Company S
Then, sell the appreciated land to Company S for a price equal to the fair market value of the land before the development. If necessary, you can arrange a sale that involves just a little money and a big remittance note that the S corporation owes you (and the other co-owners, if any). Company S will repay the note with cash generated from the sale of plots after development. As long as you have: (1) held the land for investment purposes and (2) held the land for more than one year, the sale to Corporation S will trigger a qualifying long-term capital gain at the maximum federal rate by 23.8%.
Step 3: Ask Company S to develop the land and sell it
After purchasing the land, Corporation S will subdivide and develop the property, market it, and sell it. The profit from these activities will be ordinary income passed on to you (and other co-owners, if any). If the profit from development and marketing is significant, you will likely pay the maximum federal rate of 40.8% on that income. However, the average tax rate on your total profit will be less than 40.8%, as a large portion of that total profit will be pre-development capital gains taxed at “only” 23.8%.
The sooner is probably the better
As our beloved Tax Code currently stands, the federal tax rates mentioned in this column are in effect through 2025. But you know what happens when we assume. So, the sooner you can use the S corporation development entity strategy and start selling lots, the better – from a tax perspective.
The bottom line
If you are simply selling vacant land that you hold for investment purposes, the tax results are simple. Maybe not cheap, but simple.
If you plan to develop land before selling, the S corporation development entity strategy explained here can be a big tax saver under the right circumstances. But it’s not a good DIY project. Contact your tax professional for assistance and get started as early as possible if possible.