Say you own highly appreciated land that is now ripe for development. If you cash in by subdividing the acreage, developing the parcels and selling them off for a hefty profit, it could trigger a large tax bill.
In this scenario, the tax rules generally treat you as a real estate dealer. That means your entire profit — including the portion from pre-development appreciation in the value of the land — will be treated as ordinary income subject to a federal income tax rate of up to 39.6 percent. You may also owe the 3.8 percent Medicare surtax on net investment income for a combined federal rate of up to 43.4 percent. Plus, you may owe state income tax.
Current Tax Rates on Long-Term Gains from Real Estate
Currently, the federal income tax rates on long-term gains from real estate sales for most taxpayers are generally:
• 0 percent if you are in the bottom two tax brackets;
• 15 percent if you are not, and
• 25 percent for long-term gains attributable to depreciation deductions.
However, the basic maximum rate on long-term capital gains for higher-income folks is now 20 percent (up from 15 percent).
Here are the details.
• For 2014, the 20 percent rate threshold affects single taxpayers with taxable income above $406,750 ($457,600 for married joint-filing couples, $432,200 for heads of households and $228,800 for married individuals who file separate returns).
• Higher-income folks can also get hit with the 3.8 percent Medicare surtax on net investment income, which can result in an effective maximum federal rate of 23.8 percent (20 plus 3.8).
• Long-term gains attributable to depreciation deductions claimed for real estate properties are called unrecaptured Section 1250 gains.
These gains, which would otherwise generally be eligible for the 20 percent maximum federal rate, are taxed at a maximum federal rate of 25 percent.
For higher-income folks, the 3.8 percent Medicare surtax can get tacked onto the 25 percent rate, resulting in a maximum effective federal rate of 28.8 percent (25 plus 3.8).
Life would be sweeter if you could arrange to pay lower long-term capital gains tax rates on at least part of the profit. The current maximum federal income tax rate on long-term capital gains is 20 percent, which is an easier tax rate to swallow.
The Potential Solution
Now for the good news. You may be able to take advantage of a strategy that allows favorable long-term capital gains tax treatment for all the pre-development appreciation in the value of your land. This assumes you’ve held the land for more than one year for investment (as opposed to holding the land as a dealer in real estate).
However, the portion of your profit that is attributable to subsequent subdividing, development, and marketing activities will still be considered high-taxed ordinary income, because you will be considered a dealer for that part of the process. However, if you can manage to pay no more than a 20 percent tax rate on the bulk of your profit (the portion from the pre-development appreciation), that is something to celebrate.
Three-Step Tax-Saving Strategy
With the preceding background in mind, here is the three-step strategy that might result in paying a much smaller tax bill on your real estate development profits.
Step 1: Establish an S Corporation to be the Developer
If you individually own the appreciated land, you can establish an S corporation owned solely by you to function as the developer. If you own the land via a partnership (or via an LLC treated as a partnership for federal tax purposes), you and the other partners (LLC members) can form the S corporation and receive corporate stock in proportion to your percentage partnership (LLC) interests.
Step 2: Sell the Land to the S Corporation
Next, you sell the appreciated land to the S corporation for a price that is 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 the S Corp owes you. The S corporation will pay off the note with cash generated by selling off parcels after development. The sale to the S corporation will trigger a long-term capital gain eligible for the 20 percent percent maximum federal rate as long as you:
1. Held the land for investment and
2. Owned the land for more than one year.
Step 3: Develop the Property and Sell It Off
After buying the land, the S corporation will subdivide and develop the property, market it, and sell it off. All the profit from these activities will be ordinary income passed through to you as an S corporation shareholder. If the profit from development and marketing is big, you will probably pay the maximum 39.6% federal rate. However, the average tax rate on your total profit will be much lower than 39.6%, because a big part of that total profit will be from pre-development appreciation that is taxed at a federal rate of no more than 20%. (These rates ignore the possible impact of the 3.8% Medicare surtax on net investment income.)
Example: Say the pre-development appreciation in the value of your land is $2 million. If you employ the three-step strategy above, the federal income tax rate on the pre-development part of your profit will be no more than 20 percent (the current maximum federal rate on long-term capital gains).
Assume you expect to reap another $1 million of profit from development and marketing activities. That part of your profit will be taxed at higher ordinary income rates of up to 39.6 percent.
With this two-part tax treatment, the total federal income tax hit is $796,000 [(20 percent times $2 million) plus (39.6 percent times $1 million)]. Without any planning, the entire $3 million profit would probably be taxed at 39.6 percent, which would create a $1,188,000 hit to your wallet.
That’s a difference of $392,000 in your favor ($796,000 versus $1,188,000). Nice! (These figures don’t take into account the 3.8 percent Medicare surtax on net investment income and any state income tax.)
Thanks to the two-part tax treatment created by this S corporation developer entity strategy, you can lock in the lower long-term capital gains tax rate for all of the land’s pre-development appreciation. That’s a huge tax-saving advantage if the land has gone up hugely in value.
Make Sure the Developer Entity is an S Corporation
To avoid adverse tax results, the developer entity must be an S corporation. Do not use a controlled partnership (or a controlled LLC treated as a partnership for tax purposes). The reason: You want to avoid a little-known rule that mandates high-taxed ordinary income treatment for gain from selling to a controlled partnership when the property being sold is not a capital asset in the partnership’s hands. In the situation described in this article, the land won’t be a capital asset in the hands of the developer entity. Instead, it will be considered inventory held for sale to customers in the ordinary course of the business of land development. Therefore, if the developer entity is a controlled partnership (or a controlled LLC), you would have to treat any gain from selling the land to the partnership (or LLC) as ordinary income, and pay a federal income tax rate of up to 39.6 percent. That would defeat the whole purpose! Fortunately, there is no such anti-taxpayer rule for land sales to a controlled S corporation.
Final Tip: You also don’t want to use a C corporation as the developer entity, because you don’t want to have to worry about possible double taxation of the profits from the developer entity’s development and marketing activities.