Owning highly appreciated land is always an exciting opportunity for landowners. For many of them, this means their land is ready to be subdivided and developed for a huge profit. But as with any investment, large profits usually result in big tax liabilities. If the landowners’ profits are taxable, they may be taxed at the ordinary income tax rates or at capital gains tax rates. Landowners should be aware of this reality and know how to mitigate the tax burden.

Income and Capital Gains Taxes on Land Sales 
Imagine a piece of land has been developed and subdivided into parcels. This land is highly appreciated and ready to be sold for a profit. In this scenario, the landowner is treated as a real estate developer; therefore, the entire profit from date of acquisition to date of sale is taxed as ordinary income up to 39.6%, not including the potential Medicare and state tax added on top. However, there is a way to position some of the profit into the capital gains tax rate of 20% instead.

How to Quality for a Lower Tax Rate
All development activity should be done under an S corp ownership. This can be done whether the land is owned individually or owned by an LLC with multiple partners. The landowner and all of the partners can agree to form an S corp with shares proportioned the same as the previous LLC.

After formation, the land is sold to the S corp at the pre-development fair market value. This sale is what allows the profit to be subject to the 20% capital gains tax rate. The potential tax savings are considerable when positioning the land in an S corp before development.

Why Not a Partnership? 
Selling land to a partnership could create some undesirable tax effects because there is a rule mandating land sold to a partnership be subject to the ordinary tax rate. The land is not considered a capital asset, rather inventory held for sale, so the partnership cannot recognize the sale as capital gains because the land is not a capital asset. But this rule does not exist for S Corporations.

Possible Outcome 
Instead of the entire land investment being taxed at the ordinary income tax rate of 39.6%, a portion will be taxed at the capital gains tax rate of 20%. This creates an average tax rate lower than the ordinary rate. The potential tax savings are large when positioning the land in an S corp before development.

Example Appreciated Land Sales
A landowner purchases some land in 2001 for $1,000,000. The landowner is looking to finally develop the land and sell the parcels for a profit. A profit can be attained because the land has appreciated in value to $2,500,000. Before the development phase begins, the landowner forms an S corp. The land is then sold to the S corp for a price of $2,500,000. This transaction created a net profit of $1,500,000.
($2,500,000-$1,000,000). The profit is taxed at the 20% long-term capital rate. The land is now developed and all individual parcels are sold for an additional profit of $2,000,000. This additional profit is taxed at the landowner’s ordinary income rate of 39.6%. The total tax bill is $1,092,000. ($1,500,000 profit times 20%) plus ($2,000,000 profit times 39.6%). If the landowner did not sell the appreciated land to an S corp and just developed, the tax bill would have been $1,386,000 ($1,500,000 profit plus $2,000,000) times 39.6%.  This method offers $294,000 ($1,386,000 – $1,092,000) in tax savings.

Land Sales Differ from State to State
State tax rules on land sales often differ from federal laws and may not be consistent from state to state, so you should always consult a qualified tax advisor to review your finances to offer the best advice for their specific situation.