Alternate Tax Approach for Undeveloped Land
2019 – 05/07 As I reflect on the 2018 tax season with its many tax law changes, I see several planning opportunities that may benefit clients. One of the most significant of these relates to the $10,000 limitation on the deduction for state and local taxes. As this cap affects almost every client we serve, especially those who pay high real estate taxes, we have explored various avenues to reduce its impact. Depending on your real estate holdings, we may have an answer that softens the blow of this new limit.
Good news, bad news
Let’s start with the bad news. The property taxes you pay on a principal residence or vacation home that’s exclusively for your personal use are subject to the new $10,000 cap. So if you pay $21,000 in taxes on these properties, less than half of it can apply toward your deduction. There’s not an easy fix for that.
But there is some potentially good news if you own unimproved or vacant land that you may sell in the future.
In the past you have been able to deduct real estate taxes and related expenses (as investment expenses) on unimproved land. But now that limitations on investment expenses and real estate taxes have been introduced, you may need an alternate route to take advantage of these costs rather than simply letting them go to waste.
Focus on the capital gain
Our strategy for undeveloped land focuses not on the current year deduction, but on the capital gains tax that will be paid when the property is sold at some time in the future. By capitalizing certain expenses associated with the property, the ultimate gain on the sale can be reduced by these otherwise non-deductible expenses.
These costs may include loan interest, real estate property taxes, and carrying charges, including advertising, mowing, insurance, HOA fees, upkeep cost of maintenance, and so on. These costs essentially get rolled into the cost basis of the property. If these costs total $30,000 in a given year, for instance, that amount can be capitalized, raising the cost basis of the property and reducing the gain when the property is later sold. The benefit is not immediate, but better late than never.
How to capitalize
Activating this strategy involves IRC Code Sec 266, which basically allows you to elect to capitalize any or all of the three categories – interest, taxes or other carrying charges on year-by-year basis. You can elect to capitalize some categories and not others. However, all items of the same category must either be deducted or capitalized. In other words, you can’t elect to capitalize a portion of the land’s mortgage interest and deduct the rest. Also, the election is also only available for years when you don’t have any income from the property.
You can make the IRC Sec 266 election when you are filing your annual return via the following statement:
“For tax year ………., taxpayer hereby elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize, rather than deduct, property taxes, mortgage interest, insurance expenses, and other miscellaneous carrying costs on the property at ………………………………”
An annual decision
Remember that you need to make this election each year that you want to add the costs to the basis of your unimproved real property. If you wish, you can make the election some years you own the property (when the deduction does not give you any tax benefit), and not make the election in other years (when the deduction maximizes your tax benefit). This is the reason that tax planning should consider not just the current year but your entire lifetime as a taxpayer.
If you missed the election in a prior year you can ask the IRS to allow you to use the election retroactively. This would require a Private Letter Ruling (PLR) for your specific case. As the cost of a PLR can be high, it would only make sense to request one if you know for sure that the election could save you thousands in future capital gains taxes.
If you hold undeveloped property, we encourage you talk to your tax advisor to fully understand your options. Furthermore, it is important that you keep track and keep a record of what you have elected to capitalize, as you will need those records to determine your basis when you sell the property. We can help you with this basis tracking process.