Let's say you own one or more vacant lots that have increased significantly in value, and you're ready to sell. Or, you have a valuable piece of land that you want to subdivide, develop, and sell for a big profit. In either case, you'll face a tax bill.
Assume you own the land either directly as an individual, through a single-member LLC (SMLLC), or through a partnership or multi-member LLC treated as a partnership for federal tax purposes. In this case, selling the land will look like 1 of 2 ways. Let’s take a look.
Scenario #1: The Land was Held as an Investment
If you've owned the land for more than a year and are not a real estate dealer, any profit from the sale will be a long-term capital gain (LTCG), which is taxed at lower federal rates. The current maximum federal rate for LTCGs is 20%.
Additionally, you might owe the 3.8% net investment income tax (NIIT) on part or all of your gain depending on your income. If your income exceeds the thresholds you may owe the NIIT on the lesser of your net investment income or the amount by which your MAGI exceeds the threshold.
Scenario #2: You’ve Flipped the Land/Parcel
In this case, federal income tax rules typically classify a land developer as a real estate dealer. If you’re classified as a dealer, the profit from developing and selling land is treated as profit from selling inventory. This means the entire profit, including the portion from any pre-development appreciation, will be taxed as ordinary income rather than at the lower long-term capital gains (LTCG) rates.
The maximum federal rate on ordinary income for individual taxpayers is currently 37%. You might also owe the 3.8% net investment income tax (NIIT) and possibly state income tax. As a result, the total tax liability could reach 50% of the gain.
How to Avoid a High Tax Bill
There's a strategy that allows you to benefit from the favorable LTCG tax treatment for all the pre-development appreciation of your land. However, any profit from later subdividing, developing, and marketing activities will still be taxed as ordinary income because you'll be treated as a dealer for that part. But if you can manage to pay “only” the 23.8% maximum effective federal rate (20% + 3.8%) or less on most of a large profit, that’s a win. Here’s a three-step plan to achieve that tax-saving goal.
Step #1: Establish an S Corporation
If you’re the sole owner of the appreciated land, establish a new S corporation owned solely by you to function as the developer entity. If you own the land through a partnership or an LLC treated as a partnership for tax purposes, you and the other partners can form the S corporation and be issued stock in proportion to your partnership/LLC ownership percentages.
Step #2: Sell the Land to the S Corporation
Next, sell the appreciated land to the S corporation for a price equal to the land’s pre-development fair market value. As long as the land has been held for investment and has been owned for more than one year, the sale will trigger a LTCG — equal to the pre-development appreciation — that won’t be taxed at more than the 23.8% maximum federal rate.
Step #3: Allow the S Corporation to Develop the Land and Sell it Off
the S corporation will subdivide and develop the property, market it and sell it off. The profit from these activities will be higher-taxed ordinary income passed through to the shareholder(s), including you. If the profit from development is big, you might pay the maximum 40.8% effective federal rate (37% + 3.8%) on that income. However, the part of your total profit that’s attributable to pre-development appreciation in the value of the land will be taxed at no more than the 23.8% maximum federal rate.
Ask for Help
Whether you plan to sell appreciated land that was previously purchased as an investment or sell land that was since developed, you’ll need help of a professional. Your tax bill from a sell of undeveloped land is straightforward but can look different if you’ve developed the land prior to selling. If you choose to sell your land to a S Corporation for a lower resulted tax bill, you’ll need someone like VAAS Professionals in your corner. We can help you avoid pitfalls and ensure that each step is taken correctly.
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