How can I reduce my capital gains taxes on the sale of vacant land?
Q. How much must I pay in capital gains taxes from the sale of a piece of undeveloped property? Are there things I can do to reduce my tax bill?
A. If you held the property for more than one year, the profit from the sale is generally treated as a long-term gain and taxed at a maximum rate of 15% in 2011. If you owned the property for a year or less, the gain is usually considered short-term and is taxed at ordinary income rates as high as 35%.
To lower your tax bill on the gain from your land sale, you might look at:
Hanging on until the gain qualifies for favorable long-term capital gains tax treatment if you've owned the property for less than a year. This could save a considerable amount of money, particularly if you are in a high income tax bracket. Someone in a 35% federal tax bracket with a profit of $50,000, for example, would pay $17,500 in short-term capital gains taxes by selling the land after a year or less of ownership versus $7,500 in long-term capital gains taxes if the land were held for more than a year.
Lowering your taxable income. The lower your federal income tax bracket, the less tax you'll pay on the capital gain. This year, those in a federal tax bracket of 15% or lower ($69,000 or less in taxable income for married couples filing jointly, $34,500 or less for singles) pay no tax on long-term capital gains. To meet those income thresholds, you might contribute as much as possible to a retirement plan, defer bonuses until next year, make full use of any tax deductions you're entitled to or take other steps that will reduce taxable income.
Receiving installments. Receiving installment payments on a land sale from the buyer over several years could help you avoid a large lump sum payment that would raise your tax bracket and your tax liability this year.
Exchanging instead of selling. Instead of selling a property and investing in another one, which could generate a capital gains tax, many real estate investors conduct what's called a 1031 Exchange. Also called an in-kind exchange, this type of transaction allows the real estate owner to defer capital gains taxes by selling one property and replacing it with another, similar one within a specified period.
There are a number rules to follow. The IRS requires those involved in the exchange to work through a neutral third party conduit called a qualified intermediary, usually an attorney or real estate professional. You must find a similar property within 45 days of selling the one you own. And to avoid immediate taxes, you must use all of the proceeds from the land sale to buy a replacement property.
Donating the land to charity. If you don't need the money from the sale and feel generous, you can get a tax deduction by donating the land to a qualified charitable organization. If the land is worth more than $5,000, you'll need to hire an appraiser to determine its fair market value and the amount of the deduction.
Knowing your cost basis. You did not mention whether or not you inherited the land. If you did, any gain when you sell will be based on its market value at the time of the inheritance, which may be higher than what the original buyer paid. A higher cost basis means a smaller gain and lower taxes.
Be aware that the best way to handle land sales will vary depending on a number of factors such as how much the land has increased in value, your income, whether it will be used for agricultural purposes or even whether it sits next to your house.
State tax rules on land sales often differ from federal ones and may not be consistent from state to state.
That's why we always urge readers with questions like this to consult a qualified tax adviser who can review their finances and offer the best advice for their specific situation.