The concept of Land Banking refers to buying land with the plan to holding it while the value appreciates and selling later for a profit. It seems straightforward, but with taxes involved, things can quickly become complex. The key question is whether the profit you make gets taxed as ordinary income (which can be a much higher rate) or as long-term capital gains (which is usually taxed at a lower rate).
Understanding the difference between these tax rates is crucial — capital gains can mean a lot less in taxes. But if the IRS sees your land buying and selling activities as a business, you might end up paying taxes at ordinary rates, which can really add up.
What You Need to Know About Land Banking
1.Your Intent for the Land: The IRS is big on your intent when you buy the land. If you’re buying land to flip it quickly, it could be viewed as a business activity, which would be subject to ordinary tax rates. But if your plan is to hold it and let the value grow, you’re more likely to be treated as an investor, which could lead to long-term capital gains treatment, assuming you hold the investment for longer than 12 months.
2. No Development Before Selling: If you start doing heavy development work—like building roads or utilities—on the land, the IRS may see that as part of a business operation, not just investment. Keep it simple and avoid major changes to the land if you want to stay within the “investor” category and avoid paying taxes at ordinary rates.
3. Selling to a Related Entity: If you decide to sell the land to a related company, like an S corporation, make sure the deal is structured properly. In Bramblett v. Comm, the taxpayer held the property while it was appreciating and then sold the property under an installment agreement to an S Corporation that the taxpayer controlled. By using this strategy, the taxpayer was able to lock up the appreciation prior to the sale as subject to capital gains rates. In this case the taxpayer sold the property to the S Corporation for development to freeze the appreciation that had occurred to ensure it was subject to capital gains rates.
4. Choosing the Right Entity: When setting up your business to develop land, an S corporation is often the best way to go. Partnerships might come with higher taxes or risk your sale being taxed at ordinary rates, which can mean more tax headaches down the road. Partnerships have to contend with IRC Section 707, which characterizes gains as subject to ordinary income rules. S Corporations do not have a similar provision.
How to Avoid Getting Stuck with Higher Taxes
• Plan Ahead: A good tax strategy starts with careful planning. Be sure to think through how you buy and sell land, and make sure you’re using the right type of business structure. Avoid doing anything that might make the IRS classify you as a “dealer” in land, which makes a transaction subject to ordinary rates.
• Document Everything: Keep good records — everything from purchase agreements to sales contracts. If the IRS questions you, having that paperwork on hand will help you show that you’re on the up-and-up.
• Have a Legit Business Purpose: If you’re selling land to an entity you control, like an S Corporation, be sure that there’s a legitimate business reason for doing so. Ensure that if the sale is done on an installment basis, that the loan is at arms-length and payment terms are consistent with market
At the end of the day, land banking can be a smart investment strategy if you’re patient and understand the tax rules. You can capture appreciation at long term capital gains rates before you develop the property. Once you begin development of land, you run into being classified as a dealer which leads to ordinary tax rates on any gain. Each set of facts is unique, and the rules are complex, but if you get in touch with a tax professional when purchasing land for development, there are strategies to maximize the amount of gain subject to capital gains rates.
At Duner and Foote, we specialize in helping individuals and businesses navigate the complex world of taxes—whether you’re buying land as an investment or selling it down the road. We’re here to help you navigate the financial side of real estate with expert accounting and tax services. Contact us today for a consultation.