Before You Start Development on that Land Investment…
Land prices have been recovering since the Great Recession. People who hold land for investment may be interested in developing then selling the land. If held for more than 12 months, gains from sales of investment real estate are subject to favorable capital gain rates (generally 15%, but up to 23.8% for high income individuals). However, people who do any development of the land generally will not qualify for capital gain treatment; they will be subject to ordinary income rates (up to 43.4%) on their entire gain from the sale of developed land.
Example: Jane owns a parcel of land she bought as an investment 20 years ago. She originally paid $200,000 for the parcel and it is now worth $300,000. Jane has not performed any development activity on the land. If she sells the land, her gain of $100,000 will be subject to the favorable capital gain tax rate of 15%. Her tax on the sale will be $15,000.
Example 2: Same as above, except that Jane spent $20,000 improving and developing the lane. She sells the parcel for $350,000. Her cost basis in the land is the $200,000 purchase price plus the $20,000 she spent on improvements–$220,000. If she sells the land for $350,000 her gain will be $130,000. Since she began developing the land, the gain of $130,000 no longer qualifies for capital gain treatment. The gain will be taxed at ordinary income rates. If Jane is in the 28% tax bracket, the tax on her gain will be $36,400.
Tax Strategy: Sell the Undeveloped Land to Your S Corporation
Through a tax-saving strategy, it is possible to have pre-development gains subject to the capital gain tax rate, and only gains from development will be subject to ordinary income rates. This is done by selling the investment land to an S corporation that the real estate investor owns before performing any development activity.
Example: Carrying on with the same fact scenario as above. Instead of developing the land herself, Jane first sells her investment property that she purchased for $200,000 to her 100% owned S corporation. The purchase price is the $300,000 market value of the land. She recognizes a $100,000 gain that is taxed at the 15% capital gain tax rate. Her tax on the pre-development gain is $15,000.
Her S corporation will now develop the land. The S corporation spends $20,000 to develop the land and the land is now worth $350,000. The S corporation’s cost basis in the land is the $300,000 purchase price plus $20,000 development costs–$320,000. When the S corporation sells the developed land for $350,000, it recognizes a $30,000 gain that is taxed at Joan’s ordinary tax rate of 28%. The tax on the $30,000 gain is $8,400. Her and her S corporation’s total tax is $23,400.
The Tax Savings
If she developed the land herself, her total tax would be $36,400 on $130,000 of total gain. By first selling the land to her S corporation, she is able to preserve capital gain treatment on the pre-development gain ($100,000) and only pays ordinary income tax rates on the gain allocable to development ($30,000). Her total tax with the S corporation strategy is $23,400. She saved $13,000.
Strategy Does NOT Work with an LLC
This strategy will generally only work with an S corporation. It will not work with LLCs because there is a rule denying capital gain treatment when an LLC owner sells property to his LLC and the property is ordinary income property of the LLC. Since the property held by the LLC will be sold at ordinary income rates, the LLC owner’s gain on the sale to the LLC will also be ordinary income.
Make Sure It’s a Bona Fide Sale for Fair Market Value
For this strategy to work, the sale to the S corporation must be a bona fide sale for fair market value. There should be a sales agreement, and if the sale is on an installment agreement, regular payments should be made and interest to the S corporation should be charged.
If you have any questions on how this applies to you, please feel free to give us a call at 248-538-5331.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.