Let’s say you own highly appreciated land that’s now ready for development. It could result in a significant tax burden if you subdivide it, develop the individual pieces, and then sell them off for a healthy profit.
In this case, the tax rules generally treat you as a real estate dealer. This means that your whole profit – including the share resulting from land value appreciation prior to development – will be subject to a federal rate of up to 37% and classified as high-taxed ordinary income. You may also owe the 3.8% Net Investment Income Tax (NIIT), for a total federal rate of up to 40.8%. On top of that, you may owe state income tax.
If you could arrange to pay lower long-term capital gain (LTCG) tax rates on at least some of the earnings, that would be preferable. The current top federal income tax rate on long-term capital gains (LTCGs) is 20%, or 23.8% if the NIIT is due.
Potential Tax-Smart Solution
Thankfully, there is a method that enables favorable LTCG tax treatment for all land value appreciation that occurs prior to development. For investment purposes (as opposed to owning it as a real estate dealer), you had to have owned the land for more than a year.
Because you’ll be treated as a real estate dealer during that stage of the process, the share of your profit attributable to subsequent subdividing, development, and marketing activities will still be regarded as high-taxed ordinary income.
However, it is cause for celebration if you are able to pay a 20% or 23.8% federal income tax rate on a sizable portion of your profit (the pre-development appreciation portion).
A 3-Step Plan
The following three-step plan could help you pay less in taxes on your real estate development income.
- Create a S corporation.
If you are the sole owner of the appreciated land, you can create a S corporation to serve as the developer. You and the other partners (LLC members) can form the S corp and get corporation stock in proportion to your respective partnership (LLC) interests if you hold the land through a partnership or an LLC that is recognized as a partnership for federal tax reasons.
2. Sell the S Corp the land
Sell the appreciated land to the S corporation for the fair market value of the land prior to development. If necessary, you can arrange a transaction that pays you a sizable sum of money in installments from the S corp. After developing the plots, the company will sell them to raise money to pay off the loan. As long as you retained the land for investment purposes and owned it for more than a year, the sale to the S corp will result in an LTCG that qualifies for the 20% or 23.8% rate.
3. Develop the property and sell it
The S corp will develop the property, subdivide it, advertise it, and sell it. As a S corp shareholder, you will get higher-taxed ordinary income as a result of these activities. In the event of a sizable profit, you will likely be required to pay the maximum 37% federal rate (or 40.8% with the NIIT). However, because a significant portion of your overall earnings will be lower-taxed LTCG from pre-development appreciation, the average tax rate on it will be significantly lower.
Favorable Tax Treatment
You can secure favorable treatment for the land’s pre-development appreciation thanks to the tax treatment created by this S corp developer plan. If the value of the land has increased, that represents a significant tax benefit. If you want additional details or have any questions, contact us.