Raw land can be lucrative because of low buying prices and untapped value. But the prospect of paying larger taxes can be daunting.
After all, who wants to pay interest to finance an acquisition, then shell out property taxes on land with no property and still have taxes to pay over the sale of the vacant land. Don't worry, there are reasonable cost deductions available to vacant landowners.
The allowable costs selling raw land are the expenses of holding and improving the land, interest paid when leverage-financing the property, and any property taxes paid on the vacant land. You can position yourself as a real estate dealer or a private investor to qualify for different deductions.
In this article, you'll discover which deductions are available to you as a real estate dealer and the ones that are allowable to you as an investor. It is important to know the nuances so you can legally qualify for minimal taxes.
The two tax positions have different requirements, with the private investor role being easier to establish. But if you're a real estate dealer, you're taxed differently, which means the allowable costs are viewed differently. Let's start by looking at these deductibles and whether they're worth getting a real estate license for.
Table of Contents
For Real Estate Dealers
If you are a real estate dealer, the ownership of raw land is seen as a business operation. For this, you must have the appropriate license and enough transactions to justify the view. The advantage of being in the real estate dealer category is that all the expenses associated with being the landowner are allowable costs you can deduct from your taxes.
Applicable Tax Deduction: Business Expenses on IRS Schedule C
If you're a sole proprietor, the tax deduction will go as a business expense on IRS schedule C. This is where you can deduct the sum total of the express costs of owning and maintaining raw land. Notice how the expenses of holding the land aren't mentioned here. This is mainly because the primary cost of having land is depreciation, which you cannot deduct as a real estate dealer.
Applicable Tax: Personal Income
As a real estate dealer, the tax you incur is not the capital gains tax but personal income tax, especially if your business is a pass-through entity. A pass-through entity is one where the tax burden passes to the owners, and the business itself isn't taxed. A sole proprietorship is a pass-through structure.
Not Allowed Depreciation Deductions
It is not a major disadvantage that deductions aren't allowed if the land depreciates because real estate dealers hold the land for a very small time frame, sometimes lasting less than 24 hours. However, it is worth noting for those who are considering the real estate dealer tax position. Despite allowing all business expenses deduction, the overall tax frame isn't land-holding-friendly.
Allowable Costs for Real Estate Dealers
Having covered what cannot be deducted from taxes if one assumes the real estate dealer position, let's look at the actual allowable costs. As long as the following are relevant to raw land ownership, they can be deducted from your annual income tax.
Interest on Loans
The loan you acquire to buy raw land comes with interest. Said interest can be deducted as a cost of doing business. For this to apply, 100% of the loaned amount must be used in a tangible way directly in the service of your business.
Usually, your loan application includes the purpose of the loan. It should mention the specific land you wish to acquire alongside a reasonable valuation. Real estate dealers rarely buy raw land with leverage, so this allowable expense is rarely used and deducted.
Raw land can have property taxes unless it is zoned (or meant) for exclusive use as agricultural land. If you have to pay any new taxes because you own land, you can deduct the dollar amount as a business expense. To incur property tax, though, you need to hold the land for a while, which doesn't happen if you're a dealer.
If you physically visit the land to examine it or show it, you can deduct the cost of gas/travel as the cost of doing business. This has to be within reason because if 50% of your revenue seems to be vanishing in the form of gas expenses, the IRS will want to look further into your business. Keeping gas station receipts helps!
Raw land can have maintenance expenses too. Whether you put a sign on the lot or a fence around it, anything you do directly to the land that incurs an expense counts as an allowable cost. If this is ever questioned, your tax advocate should be able to argue the expense as serving the business by directly or indirectly creating a profit.
If you go beyond a traditional real estate dealership and are engaged in flipping raw land, then your expenses (and consequent deductions) will be much larger. These costs could include the extension of utilities, large-scale cleaning, and even digging, building, and evening-out the land.
Using the real estate dealership structure to flip land can be tax-friendly in some states. You just need to see whether there is any relief in incurring a personal income tax on the sale or paying capital gains tax on the land.
For Private Investors
It doesn't take too much thinking to see that it is better to be taxed as an investor instead of being seen as a real estate dealer. This is because the greatest risk in owning raw land is the potential depreciation.
There is no tax reward for depreciation if you are taxed on your personal income. As a private investor selling raw land after owning it results in a capital gains tax if you sell after one year of holding.
Applicable Tax Deduction: Personal Itemized Deduction on Schedule A
Given that the applicable tax is the capital gains tax, the depreciation of the land gets removed from the overall profit. But if the depreciation is deducted already, the capital gains will not be offset by the loss when being calculated for taxes.
The allowable costs are broadly deductible from the holding period than during or after the sale. That's because you're not in the business of buying and selling land, and your acquisition isn't seen as a business move.
As it is considered a private investment, the allowable costs must be itemized as a personal deduction. If you don't itemize and deduct these expenses, you will need to use a cost basis to get them out of the total tax you pay on the final sale.
Allowable Costs for Private Investors
Now that you know how the IRS views your land-holding and its sale, you can determine which deductions to itemize for a holding period. The same expenses can also be added to your land's cost basis, so they are allowable in the sale context instead of being spread over the holding period. Let's start by looking at these potential deductions.
This happens to be the only allowable cost that is valid for real estate dealers as well as private investors. However, there is a caveat for investors because the maximum they can deduct as an interest item should not exceed your net investment income.
In other words, if you don't have any investments already flowing cash your way, the interest you pay on the loan cannot be itemized for deduction as an investment expense. This boundary is very important to understand as it self-regulates investors from private owners and also sets the pace for your future investments in raw land or developed real estate. The following example illustrates the rules of this investment expense deduction.
If you have one multi-family home currently on rent, grossing $648,000 a year and incurring $48,000 in maintenance and other expenses, your net investment income is $600,000. This means that if your loan can acquire $600,000 in interest alone within the year, you can deduct it as an investment expense.
In contrast, if you're just starting out and your salary is $648,000 a year but none of your investments are netting a profit, you have a net investment income of $0. That means that even if you have to pay an interest of $1 during the year, you cannot deduct it as an investment expense within that year. Still, you can deduce it from the next year's income.
While private homeowners have to pay property taxes, you can deduct 100% of property taxes as an investment expense as long as the raw land you acquire is held as an investment. Homes are harder to prove as investments, and sometimes even shorter stays can result in disputes and debate regarding the nature of the property.
Raw land is easily seen as an investment, even if your initial intention is to hold the property to build a personal vacation property later on. It is also worth noting that no matter what your net-investment income is, property taxes can be deducted from your annual taxes.
In a scenario where the capital gains tax equals the sum total of your property taxes and allowable interest cost, you can come out paying 0% capital gains tax. However, trying to score a zero percent tax is not the goal, as an investment becomes inefficient trying to beat taxes beyond a certain threshold.
Minimizing taxable income while maintaining a healthy return ratio is the goal of selling land. And one of the best ways to do so is to add the expenses to the land's cost basis. It results in significantly less taxable income.
Cost Basis Explained for Allowable Deductions
Consider the two main costs covered above: property taxes and interest paid on the loan that financed the acquisition. These can be itemized during the holding period but can expose you to a larger taxable position in the future. But if the same costs are included in the land's cost assessment, the net taxable profit is much lower when the land is sold.
Let's suppose you bought a small piece of raw land in a remote rural location at $30,000. Because of its position, the property tax was $100, and the loan was given at a higher interest rate because of the lack of faith in the land. Having paid $2,400 in interest, your total deductible costs add up to $2,500.
Going cost basis means adding your expenses to the land's initial price. If you sell the land for $35,000, you don't assume a capital gain of $5000. Your cost basis is $37,500 ($30,000 + $2,500), so your taxable profit is $2,500. Here is what you can add to your land's cost basis.
- Any money spent on improving the land.
- Interest paid on loans that financed the acquisition.
- Property taxes paid.
- Commissions paid to sell the land.
If you plan to sell raw land after a short holding period, having a real estate dealer position doesn't give you significant tax breaks. But if you have no investment income and are taking out a loan with an interest rate equal to the sum-total applicable tax, you can come out with 0% tax for the year.
The highest allowable cost for selling raw land for real estate dealers is the cap-free deduction for the interest paid on loans. If the interest you pay on loan for the property doesn't exceed your net income over the holding period, you're better off positioning yourself as a private investor when paying taxes.
About THE AUTHOR
Brittany has been in the land business since 2020 when the world was starting to shut down. Since then, we’ve sold to dozens of people from ATV weekend warriors to camping enthusiasts to retired truck drivers. Our inventory spans mostly in the western United States. We’ve been trained by experience, land acquisition courses, and hundreds of hours meeting with county assessors and clerks, zoning officials, realtors, and land investors. We’ve answered hundreds of questions from people regarding the buying and use of land.Read More About Brittany Melling