Selling Appreciated Land? Use the S Corporation to Lock in Favorable Capital Gains Treatment

Real estate values have surged in many parts of the country and are still surging in some areas. That’s good news if you’ve been holding raw land for investment.

You might be ready to cash in by subdividing and developing your acreage and selling off parcels for big profits. Great, but what about taxes?

Good question, because there’s a big issue to consider.   

The Tax Issue

When you subdivide, develop, and sell land, you’re generally deemed for federal income tax purposes to be acting as a dealer in real property who is selling off inventory (developed parcels held for sale to customers).

That’s not good, because when you’re classified as a dealer for tax purposes, all of your profit from land sales—including the part attributable to pre-development appreciation in the value of the land—is considered ordinary income. So, it’s taxed at your regular federal rate, which (for now) can be up to 37 percent.

You may also get hit with the 3.8 percent net investment income tax (NIIT), which (for now) can push the effective federal rate up to as high as 40.8 percent (37 percent + 3.8 percent). Ugh!

Seeking a Better Tax Result

It sure would be nice if you could pay lower long-term capital gains rates on at least part of your land sale profits.

For now, the maximum federal rate on long-term capital gains is 20 percent. With the 3.8 percent NIIT added on, the maximum effective rate (for now) is “only” 23.8 percent (20 percent + 3.8 percent). That’s a lot better than 40.8 percent.

Fortunately, there’s a way to qualify for favorable long-term capital gain treatment for the pre-development land appreciation, assuming you really and truly have held the land for investment.

In other words, this assumes you’re not already classified as a real property dealer.

But profits attributable to the later subdividing, development, and marketing activities will be considered ordinary income collected in your capacity as a real property dealer. Oh well.

Since pre-development appreciation is often the biggest part of the total profit, you should be overjoyed to pay “only” 20 percent or 23.8 percent on that piece of the action. The rest of this article explains a way to achieve this tax-saving goal. 

Form an S Corporation to Function as a Developer Entity

Say you form a new S corporation.

Then you sell your appreciated raw land to the S corporation for its pre-development fair market value (FMV). Great idea! As long as you’ve

• held the land for investment rather than as inventory as a real property dealer, and
• held it for more than one year,

then the sale to the S corporation will qualify for lower-taxed long-term capital gain treatment.

So, for now, you’ll lose (at most) “only” 23.8 percent of your whopping long-term gain to the feds.

After buying the land from you, the S corporation then subdivides and develops the property, markets it, and sells it off. The profits from these activities are ordinary income that’s passed through to you and taxed at your personal rates.

But this is a great tax-saving deal when the land is highly appreciated to start with. 

To sum up, the S corporation developer entity strategy allows you to lock in favorable long-term capital gain treatment for the pre-development appreciation of the land while paying higher ordinary income rates only on the additional profits from development and related activities. Good strategy.