The IRS considers land to be a capital asset just like other types of real estate or shares of stock. As such, when you sell it, you will be liable for capital gains tax if the sale is profitable. Furthermore, if you depreciated land improvements, you will also need to pay depreciation recapture tax on them. However, there may be ways to dispose of your land without incurring tax liability.
Sell at a Loss
If you sell your land for less than what you paid for it and less than the value after adding up any depreciation that you claimed, you won't have to pay any capital gains tax. While this is not always a desirable option, it can be a way to get out of the expense of holding land for which you have no other use.
Complete a 1031 Exchange
If you intend to use the proceeds of your land sale to buy more investment property, set up a 1031 Exchange. This will allow you to carry your depreciated cost basis forward to your new property and defer payment of capital gains and recapture taxes until you cash out the real estate holdings.
You will require the services of a qualified intermediary, which is a third party not otherwise related to you or the transaction, but for many landowners, a 1031 Exchange is the best way to complete a tax-free sale of appreciated land. Note that while a qualified intermediary can be anyone who has not been a part of the transaction or who has not represented you in certain ways in the last two years, selecting a secure and experienced party – like a reputable firm that specializes in 1031 Exchanges – is wise.
Carry Back Interest-Only Seller Financing
Another way to defer payment of capital gains tax is to offer to finance the property for the buyer. If you finance it on an interest-only basis, the buyer will make interest payments but will not pay anything toward the principal, leaving your capital gains locked in the property.
This strategy has two drawbacks, though. Once the buyer pays off the loan, you will receive the principal and realize your gain, so it is only a temporary solution. The other drawback is that any down payment will also be treated as a portion of your capital gain, so it does not completely protect you from paying capital gains tax.
The Cost of Paying Taxes
Should you choose to sell your land and pay taxes, you could be subject to as many as four different taxes. Your profit on your land will be taxed at the federal capital gains rate, which is 15 percent or 20 percent for assets held over one year, depending on your income. You could also be subject to a 3.8 percent surcharge tax for Medicare as well as 25 percent depreciation recapture tax on any depreciated land improvements. Finally, you may also have to pay taxes to your state on the profit.
Lease the Land Instead
Depending on what the buyer intends to do with your land, you might not need to sell it at all. Many buildings are constructed on leased land. The property owner retains the land but agrees to let the lessor use it for a set period of time in exchange for making payments on a ground lease.
You might receive less money for leasing your land, but you'll still own it in the long term. Also, since you don't sell, you don't realize a taxable capital gain.
- IRS: Topic 409 - Capital Gains and Losses
- RentalSoftware.com: Real Estate Investors Beware: The Capital Gains Unrecaptured Section 1250 Gain Tax Trap
- First American Exchange Company: Frequently Asked Questions
- API: Impact of the 2018 Tax Law on Real Estate Owners
- The Motley Fool: Your Guide to Capital Gains Taxes in 2018
- Kiplinger: Depreciation's Tax Break Has Consequences for Real Estate Investors
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.