Suppose you've been holding raw land that you bought years ago as an investment. Now you figure it's time to cash in on the building boom in your area.
Strategy: Subdivide the land, and sell it in separate parcels. That way (as long as you stay within the tax laws), all your profit is treated as tax-favored capital gain. Starting with sales that occur after May 5, 2003, the maximum rate on long-term capital gain drops to 15 percent.
On the other hand, if you're classified as a real estate "dealer" instead of an investor, your profit is taxed as ordinary income. And even if you avoid the "dealer" tag, part of your gain could be taxed as ordinary income if you're not careful. (IRC Section 1237) Here's the lowdown:
Earn real estate 'investor' label
If you own a tract of land and subdivide it into individual parcels for sale, you can qualify for capital gain treatment (i.e., you're an investor, not a dealer) if you meet the following four requirements:
1. You've made no major improvement to the land or contracted with a buyer to do so.
2. You've owned the land at least five years (or acquired it by inheritance or another way).
3. You didn't previously hold the land (or any subdivision it) for sale.
4. You're holding no other property for sale in the year of the sale.
Assuming you meet those requirements, your entire gain is treated as capital gain if you sell less than six lots from the tract. When determining the number of lots sold, consider this: two or more adjoining lots sold to the same buyer in a single sale are counted as one lot.
If you sell six or more lots from the same tract of land in one year, you must treat 5 percent of the selling price (reduced by your selling expenses) as ordinary income, subject to higher tax rates.
One caveat: If you sell the first five lots in one year and then sell the sixth lot in the following year, the 5 percent rule only applies to the lot sold in the second year (and any subsequent sales of lots from the same tract).
The lesson: If you're subdividing a piece of raw land into six or more lots, spread the deal over two years. That will minimize tax on the deal.
Example: Say you own a tract of land that you've subdivided for sale. After selling five lots in 2003, you sell a sixth lot this year for $20,000. Your basis in the sixth lot was $10,000 and your selling expenses are $900. Since 5 percent of the sales price is $1,000, only $100 of your gain is taxed as ordinary income ($1,000 minus $900). The remaining $9,000 of profit ($10,000 minus $900 selling expenses minus $100 ordinary income) is taxed as capital gain.
Final note: The 5 percent rule does not apply to losses. If you sell a subdivided lot at a loss, it will be treated as a capital loss regardless of the number of lots sold.