To determine capital gains on a piece of land sold this year, can I deduct the real estate taxes paid over the time of ownership?
-Jonce
Dear Jonce,
Someone has been doing their homework! Nice job rooting out allowable ways to reduce the capital gains on the sale of land. The answer to your question is yes. You can “deduct” real estate taxes that were paid over the course of owning a piece of land in the year the land is sold, providing the land was vacant and not used for a specific purpose, such as grazing, farming, etc. But, like most tax benefits, there is a catch. First of all, claiming real estate taxes paid in the year vacant land is sold is not considered a “deduction,” per se. It is an election to capitalize the annual real estate taxes paid on vacant land instead of claiming the real estate taxes paid as a deduction. In essence, an expense is capitalized by adding the amount of the real estate taxes paid to the basis of the vacant land. (Below is a brief explanation of the meaning of basis as it refers to vacant, unproductive land.) In addition to electing to capitalize the real estate taxes paid, a taxpayer may elect to capitalize the mortgage interest paid during the year on the property. Be aware that in any year the real estate taxes are claimed as a deduction on your income tax return, the election to capitalize the real estate taxes paid is not available. Brace yourself because here is where the catch comes in, and like a band-aid that has been on too long, it might sting.
The election generally must be made in the year the real estate taxes are paid. This is not a one-time election, which means the election must be made every year a taxpayer wants to capitalize instead of claiming a deduction, even if the taxpayer did not have enough deductions to itemize. The election is not automatic and is made by including a statement when you file your income tax return that indicates you are electing to capitalize the real estate taxes paid in connection to the vacant/unproductive property you own. The election should include the property location and the amount of real estate taxes paid.
So, if you have owned the land for several years and have not made the election every year, you may not be able to add to the basis the property taxes paid in prior years. Here is where there may be some good news. The IRS has the discretion to grant a taxpayer a reasonable extension of time to make certain tax elections that were not requested timely, providing the taxpayer acted reasonably and in good faith. To make the request, a Private Letter Ruling will need to be submitted to the IRS Office of Chief Counsel. A private letter ruling is a formal request, and there is a fee to submit one to the IRS. The fee is not cheap and can cost up to $38,000. Furthermore, it can take months for the IRS to issue their response. For taxpayers whose gross income is less than $250,000, the fee may be reduced to $3,000, which is still a hefty sum for most taxpayers. Because of the high cost of requesting a private letter ruling, a taxpayer should carefully weigh the pros and cons and if the cost is worth the tax savings. It is recommended that a taxpayer seek a tax professional’s advice when considering requesting a private letter ruling or making a capitalization election.
A word about determining the basis of your land
If you purchased the land, your basis is the amount you paid plus certain closing costs. The basis of inherited property is generally the property’s fair market value as of the date the owner passed away. Generally, you can get this information from the person who handled the estate of the person who passed.
If the land was gifted to you, determining the basis is a bit more complicated. The basis of gifted property is determined whether there is a gain or loss when the land is sold. To calculate the basis of gifted property, you will need to know the basis of the land in the hands of the person who gifted the property to you, also known as the donor. If the donor purchased the property, their basis would be the amount they paid for the property, including any real estate taxes or mortgage interest paid that was elected to be capitalized. If the property had been gifted to several different people throughout the years, then the donor’s basis would be what the original person who purchased the land paid. Besides knowing the donor’s basis in the land, you will need to know what the land’s fair market value was when you received it as a gift. The fair market value of the property on the date you received the land as a gift can be determined by a licensed appraiser. If the land is sold at a gain and the land’s fair market value is less than the donor’s basis, the donor’s basis is used to calculate the gain. Here’s an example.
Marty’s Uncle Fred gifted him a parcel of undeveloped, vacant land. Fred originally paid $40,000 for the land. When the land was gifted to Marty, the land was appraised to be worth $30,000. A few years later, Marty sells the land for $50,000. Since Marty sold the land at a gain, he will use his Uncle Fred’s basis of $40,000 to calculate the taxable gain on the sale.
When land that was gifted is sold at a loss, the land’s fair market value on the date it was gifted to the taxpayer is used to calculate the loss. Here is an example.
At the last minute, Marty’s buyer backed out of the sale. Marty found another buyer who agreed to purchase the land for $25,000. Since the land is now being sold at a loss, Marty will use the property’s fair market value of $30,000 to calculate the loss on the sale.
What happens if the gifted property is sold for a price between the donor’s basis and the fair market value of the property? In this situation, the taxpayer will not have a gain or loss on the sale.
Marty could not believe his run of bad luck. The deal he had with both of the previous buyers to buy his parcel of vacant land fell through at the very last minute. A third and final buyer came his way, and Marty is hoping his third try at selling the land will be the charm. The buyer agreed to buy the land from Marty for $38,000. Since the land sold for a price in between his Uncle Fred’s purchase price of $40,000 and the land’s fair market value at the time it was gifted to Marty ($30,000), Marty neither has a gain nor a loss. But he will still have to report the sale on his income tax return in the year it was sold.
I hope this information is helpful. Several taxpayers have been successful in requesting an extension of the time to make a late capitalization election. But remember, every person’s tax situation is unique, so there is no guarantee the IRS’s response will be in your favor. Looking for a tax professional to prepare your taxes this year? TurboTax has a
Live Full Service program where their team of tax experts consisting of Enrolled Agents, CPAs, and tax attorneys will prepare your tax return on your behalf.
Wishing you qualified tax savings and many happy returns,
Jean