Say you own some vacant lots. Like other real estate, they have appreciated big time over the last few years, and you’re ready to cash in. Or you may have a parcel that you want to subdivide into lots, develop them, and sell them off for a hopefully even bigger profit. Either way, you’ll owe taxes. Here’s what to expect.
The simple scenario: you sell vacant lots that were held for investment
If you’ve owned the lots for over a year, you’ll owe federal capital gains tax. The maximum rate for long-term capital gains (LTCGs) is 20%. But you’ll owe that rate only 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’re a married joint filer, $459,750 if you’re a single filer, or $488,500 if you use head of household filing status.
Example 1: You’re a joint filer with 2022 taxable income of $750,000 consisting of a $500,000 LTCG from selling 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). That amount of the $500,000 LTCG is taxed at the maximum 20% rate. The remaining $267,200 ($500,000 – $232,800) is taxed at “only” 15%. You’ll also owe the 3.8% net investment income tax (NIIT) on all or part of your LTCG (probably all), and you may owe state income tax too–depending on where you live.
Example 2: You’re a joint filer with 2022 taxable income of $900,000 consisting of a $350,000 LTCG from selling 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 $350,000 LTCG is taxed at the maximum 20% rate. You’ll also owe the 3.8% NIIT on all or part of your LTCG (probably all), and you may owe state income tax too. That’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’re a single filer with 2022 taxable income of $400,000 consisting of a $200,000 LTCG from selling appreciated lots and $200,000 of income from other sources after allowable deductions. Since your taxable income including the LTCG doesn’t exceed the applicable threshold of $459,750, the entire $200,000 LTCG is taxed at “only” 15%. You’ll also owe the 3.8% NIIT on all or part of your LTCG, and you may owe state income tax too. But at least you dodged the 20% bullet.
The complicated scenario: you intend to develop a parcel and then sell
Here’s the rub in this scenario: the federal income tax rules generally treat a land developer as a real estate “dealer.” If you are classified as a dealer, your 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 high-taxed ordinary income rather than lower-taxed LTCG. Under today’s rules, the maximum federal rate on an individual’s ordinary income is 37%. You may also owe the 3.8% NIIT and state income tax too. So, your combined tax rate could be 50% or higher. Yikes.
It would be much better if you could arrange to pay lower LTCG tax rates on at least part of the profit. The current maximum federal rate on LTCGs is “only” 20%. If you also owe the 3.8% NIIT, the combined maximum federal rate is “only” 23.8%. That’s much better than the 40.8% (37% + 3.8%) combined maximum federal rate on ordinary gains recognized by a real estate “dealer.”
S corporation developer entity to the rescue
Thankfully, there is a strategy that allows favorable LTCG tax treatment for all the pre-development appreciation in the value of your land. This assumes you’ve held it for investment rather than as an established dealer in real estate. Understand this: even with this strategy, any profit attributable to subdividing, development, and marketing activities will still be high-taxed ordinary income, because you will be treated as a “dealer” for that part of the process. But if you can manage to pay “only” a 23.8% federal income tax rate on the bulk of your large profit (the portion from pre-development appreciation), that’s something to celebrate.
Example 4: The pre-development appreciation in the value of your land is $3 million. If you employ the S corporation developer entity strategy explained below, that part of the profit will be taxed at a federal rate of no more than 23.8% (the 20% maximum federal rate on LTCGs plus another 3.8% for the NIIT) under the current tax regime. Say you expect to reap another $2 million of profit from development and marketing activities. That part will be taxed at ordinary federal income tax rates, which can be as high as 40.8% (37% plus 3.8% for the NIIT) under the current tax regime.
With this dual tax treatment, the maximum federal income tax hit is “only” $1,530,000 ((23.8% x $3 million) + (40.8% x $2 million)). Without any advance planning, the entire $5 million profit would probably be taxed at the maximum 40.8% ordinary income rate, which would result in a much bigger $2,040,000 hit to your wallet. Which would you rather pay: $1,530,000 or $2,040,000?
With the preceding background in mind, here’s the drill for paying a smaller tax bill on the profit from your land development activity.
Step 1: Establish S corporation to be the developer entity
If you as an individual are the sole owner of the appreciated land, you can establish a new S corporation owned solely by you to function as the developer entity. If you own the land via a partnership (or via an LLC treated as a partnership for tax purposes), you and the other co-owners can form the S corporation and receive corporate stock in proportion to your ownership interests.
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. If necessary, you can arrange a sale that involves only a little cash and a big installment note owed by the S corporation to you (and the other co-owners, if applicable). The S corporation will pay off the note with cash generated by selling off parcels after development. As long as you have: (1) held the land for investment and (2) owned the land for more than one year, the sale to the S corporation will trigger a long-term capital gain eligible for the 23.8% maximum federal rate.
Step 3: Have the S corporation develop the land and sell it off
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 you (and the other co-owners, if applicable). If the profit from development and marketing is big, you will probably pay the maximum 40.8% federal rate on that income. However, the average tax rate on your total profit will be lower than 40.8%, because a big part of that total profit will be pre-development appreciation taxed at “only” 23.8%.
Sooner rather than later is probably best
As our beloved Internal Revenue Code currently stands, the federal income tax rates mentioned in this column are in place through 2025. But you know what happens when we assume. So, the sooner you can employ the S corporation developer entity strategy and start selling off lots, the better — from a tax perspective.
The bottom line
If you’re simply selling vacant lots that you’ve held for investment, the tax results are straightforward. Maybe not cheap, but straightforward.
If you’re going to develop land before selling, the S corporation developer entity strategy explained here can be a big tax-saver in the right circumstances. But this is not a good DIY project. Contact your tax pro for assistance, and get the ball rolling sooner rather than later if possible.