The Landowners Guide to Minimizing Taxes When Selling Real Estate
Real estate ownership offers a fantastic way to build wealth. In many cases, owners benefit from incoming cash flows and capital appreciation, the ability to use leverage, lower risk and volatility than other alternative assets, and control over a physical asset.
A lesser-known but perhaps more important advantage of real estate ownership is the many tax benefits available to investors. Real estate investors can write off qualified business expenses like:
- Property taxes and insurance
- Mortgage interest
- Maintenance and repair expenses
- Property management fees
These deductions ultimately reduce a property's taxable income and lessen an owner's tax bill. Additionally, real estate owners can take advantage of depreciation and its offset on taxable income and other incentive programs.
But land ownership is slightly different. Because the property is often unimproved, specific tax incentives may not be applicable. However, you can still take advantage of mortgage interest and property tax deductions as a landowner.
Additionally, although you can't depreciate land, any improvements made to a property may be depreciable – even if there isn't a building on the ground, any roads, utilities, construction, etc., may qualify. And because the land is often not generating any gains, landowners may claim passive activity losses (PALs) in some circumstances, ultimately reducing their tax bill.
This isn't an exhaustive list, but it offers some insight into the tax benefits that real estate ownership provides.
But what about when it’s time to sell your property – what then? You’ll likely be slapped with a tax bill. But how much, and are there ways to minimize those taxes?
This article will discuss everything landowners need to know regarding taxes and property sales. But first, if you missed the first couple of articles in our landowner series, you'll want to check them out here – "When is the right time to sell your land as a landowner,” "3 tips for maximizing land value when it's time to sell" and “5 real estate investing exit strategies every landowner should consider.”
They offer some good context as we talk about real estate taxes for landowners but also provide some tips and tricks for you to make more thoughtful, calculated decisions regarding your land.
Capital gains taxes when you sell your land - how it works typically
Any time you make a purchase or sell something, Uncle Sam will want his cut. For example, when you sell a property or a piece of land, capital gains tax will be owed on any profit you made on the transaction.
Without getting too technical, the amount of capital in a transaction is calculated by subtracting the asset’s original or purchase price, plus any expenses or improvements incurred, from the final sales price. So, if you bought a piece of land for $250,000 and sold it for $400,000, your profit and taxable capital gain would be $150,000.
But at what rate are those gains taxed? The short answer is it depends.
Any time an asset is owned for less than one year, you deal with a short-term capital gain, and any profit will be treated as ordinary income. That means the profit is taxed at your regular income tax rate, potentially up to 37%.
However, if you owned the land for longer than one year, you'd be subject to long-term capital gains. Long-term capital gains are given preferential tax treatment with rates of 0%, 15%, and 20%, depending on your filing status.
Fortunately, as a landowner, you can minimize this capital gains tax burden when you sell your property. We'll discuss a couple of strategies below.
Real estate tax strategies to minimize your taxes when you sell land
Several tax strategies available to landowners allow for deferment and, in some cases, the elimination of capital gains taxes.
These arrangements all require strict adherence to IRS regulations. Therefore, consulting with a CPA or tax attorney before pursuing any of these strategies is wise.
Seller financing/installment sale
Seller financing, or owner financing, is a situation where the property owner takes on the role of the lender as opposed to a traditional financial institution. The buyer agrees to pay the seller in installments over the life contract.
Traditionally, these types of installment sales have been used by buyers to purchase properties with a potentially lower down payment and more favorable financing terms. But as a property owner, seller financing offers several benefits as well.
While the landowner won't receive a lump sum payment for your land upon the sale, they won't be slapped with a hefty capital gains tax bill in the first year. An installment sale allows a seller to spread the gains over several years, ultimately reducing the upfront tax burden.
Additionally, since the seller acts like a mortgage lender, they'll receive interest from the buyer for holding the note. This is an opportunity for a landowner to generate passive income from interest payments on the property.
Partnership/joint venture (JV) arrangement
Usually, when a property is sold, the transaction closes, and both parties have no more obligation to one another. However, in some situations, buyers or real estate developers structure an arrangement to keep sellers in the project and allow them to participate in the possible upside.
Joint ventures are designed in various ways, but it’s common that a seller "contributes" all or a portion of the value of the land to the transaction. As a result, capital gains taxes are owed on any down payment paid by the buyer, but the landowner can then defer the remainder of any gains until they eventually sell their shares of the project.
1031 like-kind exchange
A 1031 exchange is a strategy used to defer capital gains tax on the sale of a property. When the property is sold, and the gain is realized, a landowner can instead reinvest those proceeds into a "like-kind" property.
There are a series of guidelines the IRS has outlined for a transaction to qualify as a 1031 exchange, but generally, the rules are as follows:
- The replacement property must be identified within 45 days of the sale of the relinquished property
- The replacement property transaction needs to happen within 180 days
- A qualified intermediary needs to handle the transaction, and all proceeds need to be reinvested in a "like-kind" property to be deferred
While a 1031 exchange only defers taxes, it offers landowners an opportunity to sell a non-income generating asset like land into a cash flow producing piece of income real estate.
Reinvestment into a qualified opportunity zone (QOZ)
A qualified opportunity zone (QOZ) is an economically distressed community where certain new investments may be eligible for preferential tax treatment. The invested capital gains need to meet specific requirements, but if a QOZ property is held long enough, an investor can potentially eliminate taxes owed on all the gains invested.
Real estate investors have taken advantage of this strategy since its introduction through the 2017 Tax Cuts and Jobs Act. But it’s an opportunity not many landowners are aware of and could be a game changer in reducing their capital gains tax bill.
So, in practice, a landowner can sell their property and, within 180 days, reinvest the gains into an opportunity zone to defer or eliminate capital gains owed.
Does a real estate tax mitigation strategy make sense for every landowner?
Not in every case.
If your goal is to sell the land and take a lump sum of cash from the transaction, probably not. However, suppose your goal is to reduce your tax bill as much as possible and potentially reinvest into an income-producing property. In that case, a real estate tax strategy may be worth considering.
But there isn’t a one-size-fits-all answer. Every landowner’s situation is different. And depending on where we are in the market cycle and the overall health of the economy,
A real estate advisor may be able to help you add value to your project and craft a tax strategy that makes sense for your objectives.
At Marsh & Partners, we offer real estate consulting services to help landowners navigate challenging decisions impacting when and how to sell their land and maximize the land's value.
So, if any of this sounds interesting, grab some time on our calendar, and we'll begin brainstorming today.
The U.S. tax code is complex - none of this is meant to be tax, accounting, or legal advice. Instead, the material provided is for informational purposes only but gives landowners an understanding of some of the strategies available to reduce their tax bill.