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Land Held for Investment Tax Treatment Guide

7 minute read

Unimproved land is often seen as a valuable investment by real estate investors. Land is a finite resource that can be held onto and sold for the amount of appreciation occurred on the property’s value. Like all other investments, land sales are subject to taxation. However, how the land is taxed depends on several factors. This article helps assist landowners in the tax treatment of their property and provides a brief overview of other tax benefits that may be available to land owners and investors.

There are generally two types of land—unimproved and improved land. Unimproved land is vacant land that has had no major structures or utilities placed on it. Improved land is land that has been upgraded in some way, often by erecting a building or creating utility hookups. Other types of improvements may include changed zoning, completing landscaping and grading, and constructing roadways.

Real Estate Dealer or Investor?

To benefit the most from a sale of land, the landowner should determine if they are subject to the ordinary income tax rate or if they can utilize the more advantageous capital gains tax rate. A “dealer of real estate,” as defined by the IRS, will be subject to ordinary income tax rates. On the other hand, an investor in land will be able to apply the capital gains tax rates.

What is a Real Estate Dealer?

A dealer in real estate is typically an investor that purchases land to hold briefly—typically less than 12 months— then quickly sells the land for a profit. Some common factors that are used to determine if a taxpayer is a dealer of real estate are:

  • The length of time the taxpayer held the property. Holding a property only for a short period (typically less than 12 months) before selling it leans towards dealer classification;
  • The extent and nature of the taxpayer’s efforts to sell the property;
  • The extent of advertising, developing, clearing, and subdividing used to increase sales and profit;
  • How frequently the taxpayer sells property—e.g., selling land once every three years may not rise to the level of a “dealer,” but selling land every month would likely support a finding that the taxpayer is a dealer; and
  • The taxpayer’s intent. If taxpayers intend to purchase the land as part of their inventory of unimproved property to sell for a profit, they will be more likely to be classified as a dealer.

An investor who consistently purchases several pieces of unimproved property in less than a year, with the intent to sell the land for a profit, will most likely be considered a dealer of real estate. Each investor’s situation is different, and the list of factors above is non-exhaustive. This is a highly litigated area of tax law and taxpayers will want to consult with tax counsel to determine if they are considered a dealer of real estate.

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Ordinary Versus Capital Gains Tax Rate

If a landowner is a dealer per IRS standards, the ordinary income tax rate will apply to any sale of their property. However, if the landowner is not determined to be a dealer, the landowner will be able to benefit from the more favorable capital gains tax rates.

Ordinary Income Tax Rate: If the taxpayer is determined to be a “dealer,” the ordinary income tax rate will apply. For tax year 2022, the individual ordinary income tax rates are between 10% and 37%. For businesses, the tax rate will depend on the structure and entity classification of the business. For example, in 2022, the corporate tax rate is projected to be around 28%.

Capital Gains Tax Rate: If an investor in land manages to avoid being classified as a dealer, they can take advantage of capital gains tax rates. There are two types of capital gains rates—short term and long term. The short-term capital gains rate is applicable to property held for less than one year, and the applicable rate is the same as the ordinary income tax rate. The long-term capital gains rate is applicable to property held for one year or longer and rates range between 0% and 20% for tax year 2022.

Section 266 Election

Taxpayers who invest in land may be able to save on taxes when the property is sold by utilizing the annual Section 266 Election. Section 266 of the Internal Revenue Code allows taxpayers to capitalize on certain expenses related to the investment property such as taxes, interest, insurance, and maintenance costs. In simpler terms, the 266 Election allows the taxpayer to add the expenses on the property to the property’s basis (typically, basis is the amount of the property was purchased for). With an increase in basis, the taxpayer will have a lower tax gain on the property and thus will pay less taxes when the property is sold. To qualify for a Section 266 Election, the land must generally be held as an investment and not be utilized for a business purpose.

Notably, if the taxpayer elects to capitalize expenses through a Section 266 Election they cannot also deduct those expenses on their tax return. Thus, a 266 Election is most beneficial for taxpayers who are not itemizing their deductions, but are utilizing the federal standard deduction. Section 266 elections can be made on an annual basis, so a taxpayer can decide that one year it may be more beneficial to make the election because they are not itemizing, but the next year they may decide to not make the election and rather itemize the expenses.

Other Tax Benefits

Mortgage Interest Deduction: A land investor can deduct any interest paid for any mortgage that was taken out to purchase the land. This includes any mortgage insurance paid as part of the mortgage payments.

Property Tax Deduction: State and local property taxes can generally be deducted from federal taxes that were paid on the investment land.

Repair, Maintenance, Insurance, and Clearing Cost Deductions: The cost of any repairs, maintenance, insurance, clearing costs, and other expenses can often be deducted on federal taxes. This includes costs like clearing trees, hiring arborists to assess the property, maintenance on existing structures or utilities connections, installing fences or gates, and even professional fees to accountants or attorneys for services related to the property.

Like-Kind Exchanges: Taxpayers can potentially utilize a like-kind exchange, also called a 1031 exchange, to defer taxes on the gain earned from property sold. Under a like-kind exchange, an investor in land can sell the land for a similar property and have any gain of the original property deferred until the new property is sold. Notably, vacant land held solely for sale cannot utilize the like-kind exchange rules. Only vacant land held for investment, trade, or business can use like-kind exchange rules.

Next Steps

Owning vacant land can be a great investment for many. However, landowners should ensure they are planning how to handle the taxes of the property in advance while holding the land and once it is sold. Let Corvee help you navigate complex tax situations and reduce your taxes. Request a demo today!

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