Capital gains tax on land sales can significantly reduce a seller’s profit, but with careful planning, a landowner can minimize or even avoid these taxes. This article provides an overview of capital gains taxes, strategies to reduce them, and key considerations when selling land.
Seeking the help of a tax specialist is a vital first step in planning and executing a land sale.
What Are Capital Gains Taxes?
Capital gains taxes are income taxes on the increase in value of an asset. Generally, the income is based on the difference between the sale price (minus any sales costs) and the cost basis. The cost basis includes the purchase price, closing costs, and the cost of any improvements.
Calculating an adjusted tax basis helps determine the taxable gain on a sale.
Capital gains tax can be either short-term or long-term, depending on how long the asset was held. If the land was owned for less than a year, short-term capital gains rates apply, equivalent to ordinary income tax rates. For assets held over a year, long-term capital gains rates apply, which may be as low as 0% for taxpayers with lower taxable income.
Factors Affecting Capital Gains Tax on Land Sales
If a land asset’s value remains constant, an unadjusted basis is used to calculate capital gains. However, if the value changes, an adjusted basis may apply. Two main scenarios lead to an adjusted basis:
- Capital Improvements or Depreciation: Real estate improvements increase the adjusted basis, while depreciation reduces it. If the land includes depreciable assets, such as heavy machinery, an adjusted basis can be used to calculate capital gains.
- Inheritance: When an asset is inherited, it receives a “step-up” in basis, which means the basis is adjusted to the fair market value at the time of inheritance. This adjustment can help beneficiaries avoid capital gains taxes when they sell the property.
Calculating the Adjusted Tax Basis of an Investment Property
Calculating an adjusted tax basis helps determine the taxable gain on a sale. In general, a higher cost basis benefits the landowner by lowering the taxable gain. Some common increases to the tax basis include:
- Costs of improvements to the property
- Money spent to restore the property after damages
- Legal fees and utility installation costs
- Depreciation recapture taxes (for depreciable assets like rental properties or commercial buildings)
Additionally, state taxes may apply, as many states have their own capital gains tax rates and rules. Understanding state-specific regulations is essential for accurate tax planning.
Options to Avoid Paying Capital Gains Taxes When Selling Land
Several strategies can help a landowner avoid, reduce, or defer capital gains taxes:
- 1031 Exchange: This allows an investor to reinvest sale proceeds into a “like-kind” property without owing taxes on the gain. A third-party intermediary holds the sale proceeds and manages the replacement property’s purchase. Designating a replacement property must occur within 45 days, and acquisition must be completed within 180 days. Any uninvested sale proceeds, known as “boot,” are taxable.
- Deferred Sale: By deferring the sale date to a different tax year, a landowner can strategically place the income in a year when their taxable income is lower, potentially reducing their tax burden.
- Installment Sale: In this arrangement, the property is sold over several years, breaking up the taxable income into smaller, annual amounts. This approach may lower or eliminate capital gains taxes based on taxable income each year.
- Offset Gains with Capital Losses: Landowners can use capital losses from other investments to offset gains, minimizing or eliminating capital gains taxes. Losses from short-term assets must be used against short-term gains first, and the same applies to long-term losses and gains. Excess losses can offset up to $3,000 of ordinary income annually and may be carried forward to future years.
- Donate Appreciated Land to Charity: Donating land to a charity allows the landowner to avoid capital gains taxes and provides a deduction for the full fair market value of the land. Charitable deductions are limited to a percentage of adjusted gross income, and excess contributions can be carried forward for up to five years.
- Beneficiaries Sell After Death: Property left to beneficiaries receives a step-up in cost basis, meaning they only owe taxes on gains from the time of the landowner’s death. Selling the property shortly after inheritance can avoid capital gains taxes entirely.
Final Thoughts
For landowners contemplating a sale, the complexities of capital gains tax and the varying state-specific requirements make professional guidance essential. Proper planning and understanding of available options can help maximize profits while ensuring compliance with tax laws.