Individual taxpayers who own appreciated vacant land should know the tax consequences before they sell or subdivide. Here’s critical federal tax guidance for these individuals.
Important: For purposes of this article, we’ll assume that you own the lots either 1) directly as an individual, or 2) indirectly through a partnership, a multimember limited liability company (LLC) that’s treated as a partnership for federal income tax purposes, or a single-member LLC that’s treated as your tax alter ego and disregarded for federal income purposes.
Scenario 1: You Want to Sell Vacant Lots That You’ve Held for Investment
If the lots have been owned for more than one year, and you aren’t classified as a real estate dealer (see “Scenario 2” below), any gain on sale will be a long-term capital gain (LTCG) eligible for preferential federal income tax rates. The current maximum federal rate for LTCGs is 20%, but you’ll owe this maximum rate only on the lesser of:
- The net LTCG, or
- The excess of your taxable income, including any net LTCG, over the applicable threshold.
For 2022, the thresholds are:
- $517,200 for married couples who file jointly,
- $459,750 for single filers, and
- $488,500 for heads of households.
For example, suppose you’re married and file a joint return. For 2022, you’ll have taxable income of $800,000, consisting of a $550,000 LTCG from selling a couple 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 $282,800 ($800,000 minus $517,200). That amount of your LTCG from selling the lots is taxed at the maximum 20% federal rate. The remaining $267,200 of LTCG ($550,000 minus $282,800) is taxed at “only” 15%. You’ll probably also owe the 3.8% net investment income tax (NIIT) on all or part of the LTCG. You might owe state income tax, too.
Alternatively, suppose you’re still married and file a joint return. And, for 2022, you’ll still have taxable income of $800,000. But, in this case, your taxable income consists of a $250,000 LTCG from selling appreciated lots and $550,000 of taxable income from other sources after allowable deductions. Because your taxable income before any LTCG exceeds the applicable threshold of $517,200, the entire $250,000 LTCG is taxed at the maximum 20% rate. You’ll probably also owe the 3.8% NIIT on all or part of the LTCG, and possibly state income tax as well.
Scenario 2: You Want to Develop a Parcel and Sell Improved Lots
The federal income tax rules generally treat a land developer as a real estate dealer. If you’re classified as a dealer, the profit from developing and selling land is considered profit from selling “inventory.”
That means the entire profit — including the portion from any pre-development appreciation in the value of the land — will be higher-taxed ordinary income rather than lower-taxed LTCG. The current maximum federal rate on ordinary income recognized by individual taxpayers is 37%. You could also owe the 3.8% NIIT and state income tax, if applicable.
It would be advantageous if you could arrange to pay lower LTCG tax rates on at least part of the profit. As stated earlier, the current maximum federal rate on LTCGs is 20%. If the 3.8% NIIT is also owed, the maximum effective federal rate is 23.8%. That’s much better than the 40.8% (37% ordinary rate plus 3.8% NIIT) maximum effective federal rate on ordinary gains recognized by a real estate dealer.
S Corporation Developer Entity Strategy
Thankfully, there’s a strategy that allows favorable LTCG tax treatment for all the pre-development appreciation in the value of your land. This assumes that you’ve held the land for investment rather than as a dealer in real estate.
Important: Even with this strategy, any profit attributable to subdividing, development and marketing activities will still be higher-taxed ordinary income, because you’ll be treated as a dealer for that part of the process. The maximum effective federal rate on ordinary gains recognized by a dealer is 40.8%.
But, with the S corporation strategy, you’ll owe — at most — the 23.8% maximum federal income tax rate on the part of the profit that’s attributable to pre-development appreciation.
To illustrate, let’s say the pre-development appreciation in the value of your land is $3.5 million. If you employ the S corporation developer entity strategy, that part of the profit will be taxed at an effective federal rate of no more than 23.8% under the current tax regime, resulting in a tax hit of $833,000 ($3.5 million times 23.8%). Now suppose that you expect to reap another $2.5 million of profit from development and marketing activities. That part will be taxed as ordinary income, which can be taxed at a maximum effective federal rate of 40.8% under the current tax regime, resulting in a tax hit of $1.02 million ($3.5 million times 23.8%).
With this dual tax treatment, the maximum federal income tax hit is $1.853 million ($833,000 plus $1.02 million). Without any advance planning, the entire $6 million profit would probably be taxed at an effective federal rate of 40.8%, which would result in a much bigger $2.448 million hit to your wallet ($6 million times 40.8%). So, this strategy could potentially save you as much as $595,000 ($2.448 million minus $1.853 million).
3 Steps to the S Corp Strategy
Follow these three steps to put the S corporation developer entity strategy to work:
1. Establish an S corporation to be a developer entity. If you’re the sole owner of the appreciated land, you can establish a new S corporation that’s 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 partnership or LLC ownership percentages.
2. Sell the land to the S corporation. The appreciated land is sold to the S corporation for a price equal to the land’s pre-development fair market value. If necessary, arrange a sale that involves a small amount of cash and a big installment note owed by the S corporation to the shareholder(s). The S corporation will pay off the note with cash generated by selling off parcels after development. As long as the land has been 1) held for investment and 2) owned for more than one year, the sale to the S corporation will trigger an LTCG (equal to the pre-development appreciation) that’s eligible for the 23.8% maximum effective federal rate.
3. Use the S corporation to develop and sell the land. After buying the land, the S corporation will subdivide and develop the property, market it and sell it off. The profit from these activities will be ordinary income passed through to the shareholder(s). If the profit from development and marketing is significant, the shareholder(s) might pay the maximum 40.8% effective federal rate on that income. But the average tax rate on the total profit will be lower than 40.8%, because a portion of the total profit will be attributed to pre-development appreciation and taxed at no more than 23.8%.
Those Who Hesitate Sometimes Lose
The federal tax results are straightforward for investors who sell highly appreciated vacant land. If you develop the land, using the S corporation developer entity strategy could significantly lower the tax hit under the right circumstances.
As the Internal Revenue Code currently stands, the federal income tax rates mentioned in this article are scheduled to remain in place through 2025. But Congress could change the rules at any time. So, the sooner you can employ the S corporation developer entity strategy and sell your developed lots, the better. But it’s not a do-it-yourself project. Consult your tax advisor to help avoid potential pitfalls.