Selling land for more than you originally paid does not necessarily mean you will be taxed on the entire sale price. It also does not mean the amount deposited into your bank account will be the same as your taxable gain.

Several different numbers come into play when land is sold. Understanding the difference between the sale price, net proceeds and taxable gain can help you prepare for a conversation with your accountant before listing your property.

As discussed in our previous article, “Build Your Land Transaction Team Before Buying or Selling,” tax planning should begin before the transaction. Your LandGuy can help you understand the real estate process, while your accountant or tax professional can explain how the sale may affect your individual tax situation.

What Is a Capital Gain?

In simple terms, a capital gain occurs when you sell an asset for more than your adjusted basis in that asset. Land held for personal or investment purposes is generally considered a capital asset, although different rules may apply to land used in a business or farming operation.

A simplified calculation looks like this:

Amount realized from the sale – adjusted basis = gain or loss

The actual calculation can be more complicated, especially when the property includes depreciable buildings, farm improvements, equipment or multiple owners.

According to the IRS, a capital gain generally occurs when an asset is sold for more than its adjusted basis. A capital loss occurs when it is sold for less. Additional information is available through IRS Topic No. 409: Capital Gains and Losses.

Sale Price, Net Proceeds and Taxable Gain Are Different

These three terms are sometimes used interchangeably, but they do not mean the same thing.

Sale Price

The sale price is the amount the buyer agrees to pay for the property.

For example, if a property is under contract for $500,000, its sale price is $500,000.

Net Proceeds

Net proceeds are what the seller receives after certain costs and obligations are paid at closing. These may include:

  • A mortgage or other loan payoff
  • Brokerage fees
  • Attorney or title company fees
  • Certain closing expenses
  • Property tax prorations
  • Other agreed-upon expenses

If the property sells for $500,000, the seller may receive considerably less than $500,000 after these items are paid.

Taxable Gain

Taxable gain is calculated using the tax rules that apply to the property. It is not simply the sale price, and it is not necessarily the amount the seller receives at closing.

One important distinction is that paying off a mortgage reduces the seller’s net proceeds, but it generally does not reduce the gain for tax purposes. This is one reason sellers should not estimate their potential tax bill based only on the closing check.

What Is Adjusted Basis?

Basis is generally the starting value used to calculate gain or loss when property is sold. For land that was purchased, the starting basis is usually the purchase price plus certain acquisition costs.

That number may change during the time you own the property. After those changes are considered, it becomes your adjusted basis.

Items that may increase basis include qualifying improvements such as:

  • Constructing a building
  • Installing permanent fencing
  • Adding drainage tile
  • Building a pond
  • Installing roads or permanent access improvements
  • Adding utilities
  • Completing major renovations
  • Paying certain legal, surveying or transaction expenses connected to the property

Routine maintenance and repairs are generally treated differently from permanent improvements. For example, replacing an entire roof may be handled differently than repairing a small leak. Your tax professional can determine how a particular expense should be classified.

Basis may also be reduced by items such as depreciation previously claimed on qualifying buildings or improvements.

The IRS provides a more detailed explanation through Topic No. 703: Basis of Assets and Publication 551: Basis of Assets.

A Simplified Example

Suppose a landowner purchased a property for $200,000 and later completed $40,000 in qualifying improvements. During ownership, $20,000 in depreciation was claimed on eligible improvements.

The simplified adjusted basis might be:

  • Original purchase price: $200,000
  • Plus qualifying improvements: $40,000
  • Minus depreciation claimed: $20,000
  • Adjusted basis: $220,000

Now suppose the property sells for $350,000 and the seller has $25,000 in qualifying selling expenses.

The simplified calculation might be:

  • Sale price: $350,000
  • Minus selling expenses: $25,000
  • Amount realized: $325,000
  • Minus adjusted basis: $220,000
  • Potential gain: $105,000

This example is for illustration only. The amount that must be reported and how it is taxed will depend on the property, its use, depreciation, ownership structure and the seller’s overall tax situation.

Inherited Land May Have a Different Basis

The basis of inherited land is not necessarily what the previous owner originally paid for it.

In many cases, inherited property receives a basis based on its fair market value at the date of the previous owner’s death. Exceptions and special rules can apply, so the seller should not assume a value without reviewing the estate records with a tax professional.

Helpful records may include:

  • Estate documents
  • The date of death
  • An appraisal completed for the estate
  • County property records
  • Information about improvements
  • A prior owner’s depreciation records
  • Documents showing how ownership was transferred

If an appraisal was not completed when the property was inherited, determining its value years later may require additional research or a retrospective appraisal.

Gifted Land May Also Require a Different Calculation

Land received as a gift is generally treated differently from inherited land. In many situations, the recipient’s basis is connected to the donor’s adjusted basis rather than the property’s value when the gift was made.

This is sometimes called a carryover basis. However, different calculations may apply when the property’s value at the time of the gift was lower than the donor’s basis.

Because gifted-property rules can become complicated, sellers should gather any available records from the person who transferred the land. These may include the original purchase documents, improvement expenses, depreciation records and gift-tax documents.

Short-Term Versus Long-Term Ownership

How long the seller has owned the property may affect how the gain is classified.

Generally:

  • Property held for one year or less results in a short-term gain or loss.
  • Property held for more than one year results in a long-term gain or loss.

Short-term gains are generally taxed differently from long-term gains. The applicable rate depends on the seller’s income, filing status and other circumstances.

Inherited property and certain other situations may follow special holding-period rules. Sellers should ask their tax professional how their ownership history affects the transaction.

What Is Depreciation Recapture?

Land itself generally cannot be depreciated. However, certain assets located on the property may qualify for depreciation, including some buildings, fences, drainage systems and other improvements.

Depreciation can reduce taxable income while the property is owned. When the property is sold, however, some of the gain connected to previously claimed depreciation may be taxed differently from the remaining capital gain. This is commonly referred to as depreciation recapture.

For example, a farm sale may include:

  • Nondepreciable land
  • A depreciable machine shed
  • Grain-storage improvements
  • Fencing
  • Drainage improvements
  • Equipment or other personal property

The sale price may need to be allocated among these assets. The allocation can affect how the gain is calculated and reported.

Sellers who have claimed depreciation should provide their complete depreciation schedules to their accountant before the property is listed. The IRS discusses these rules in greater detail in Publication 544: Sales and Other Dispositions of Assets.

Remember State Taxes

Federal taxes are only part of the picture. A land sale may also create state income-tax obligations.

State rules vary, and the seller’s state of residence may not be the only state involved. If the property is located in another state, the seller may need to file or pay taxes there as well.

LandGuys serves buyers and sellers across Illinois, Iowa, Missouri, Wisconsin and Kansas. Because each state has its own tax laws, sellers should work with a professional who understands the rules affecting both the property’s location and the seller’s residence.

Records to Gather Before Listing

A tax professional can provide better guidance when accurate records are available. Before listing, sellers should begin gathering:

  • The original purchase agreement
  • The original closing statement
  • The deed and ownership records
  • Surveys and legal descriptions
  • Receipts for permanent improvements
  • Construction contracts and invoices
  • Depreciation schedules
  • Farm or rental income records
  • Prior tax returns related to the property
  • Estate or inheritance documents
  • Gift documents
  • Appraisals
  • Records of casualty losses or insurance payments
  • Information about prior partial sales or easements
  • Loan and mortgage information

Do not wait until closing to begin this search. Older documents can take time to locate, especially when land has been owned for decades or has passed through multiple generations.

Start With an Estimate, Not an Assumption

Understanding capital gains when selling land begins with determining the property’s adjusted basis. The sale price alone does not tell you how much gain you may have, how the gain will be classified or what you may owe.

Before listing, ask your accountant to help you estimate:

  • Your adjusted basis
  • Your expected selling expenses
  • Your potential federal and state gain
  • Any depreciation-related tax consequences
  • Your estimated net proceeds
  • Whether another transaction structure should be considered

Your LandGuy can provide information about the property’s potential market value and expected selling process. Your tax professional can then use that information, along with your records, to help you understand the possible tax consequences.

Planning ahead gives you time to gather documents, evaluate your options and make decisions based on more than the sale price.

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This article is provided for general educational purposes and is not intended as tax, legal or financial advice. Tax treatment depends on the property, its use and the owner’s individual circumstances. Consult a qualified tax professional, attorney or lender before making transaction decisions.