Real Property Tax Issues


Tax advantages or disadvantages may result from subdividing land for purpose of sale, foreclosing or repossessing real property you have sold, or purchasing real property from a nonresident alien. This article will briefly discuss certain tax aspects that should be considered if you wish to subdivide land you own to sell the lots, are forced to repossess real property you have sold, or if you purchase real property from a nonresident alien.

Subdivision of Real Property for Sale

It is possible that acreage you own, which you intend to sell, would be more marketable if you subdivide it before sale. To that end, consider the following preliminary information on the tax effects of subdividing the property.

In general, taxpayers who sell numerous lots of property run the risk of being classified as a real estate dealer (i.e., one engaged in the trade or business of selling real property to customers) and having all gain from the sale of such properties taxed as ordinary income. However, a safe harbor rule provides that non-corporate taxpayers and S corporations (for tax years beginning after 1996) who hold real property ("the tract") as an investment, but then subdivide it in order to make it more marketable, qualify for capital gains treatment on the sale of the tract provided:

  1. the tract was not previously held for sale to others in the ordinary course of the taxpayer's trade or business;
  2. the taxpayer does not hold any other real property for sale to others during the year in which the sale of the tract occurs;
  3. the taxpayer did not substantially improve the value of the tract; and
  4. the taxpayer has held the tract for at least five years, unless it was acquired by inheritance.

For purposes of the safe harbor, a "tract" is a single piece of real property. Two or more pieces of property that are contiguous constitute a single tract if they are separated only by a road, railroad, stream or similar property, or if they were at some time in the past contiguous in the hands of the taxpayer.

If you sell five or fewer lots from your tract, all of the gains are treated as capital gains. However, any gain realized from any sale occurring in or after the taxable year in which the sixth lot is sold is ordinary income to the extent of 5% of the selling price.

As stated above, if you make a substantial improvement to your tract, the improvement could preclude the use of the safe harbor if that substantial improvement also substantially increases the value of the lot sold. Whether any improvements have substantially increased the value of a lot depends on the circumstances in each case. If improvements increase the value of a lot by 10% or less, the increase is not considered substantial. If, on the other hand, the value of the lot is increased by more than 10%, then all relevant factors must be considered to determine whether, under such circumstances, the increase is substantial.

If you are planning on doing any improvements to your tract you should discuss the plan with a real property tax attorney who can determine whether such planned improvements will force you out of the safe harbor. Once you have decided on your course of action regarding your tract, we can review the specifics of your proposed transactions and how such specifics interplay with the rules of the safe harbor.

Gain or Loss on Reacquisition of Real Property

What if which you have been forced to repossess real property due to the buyer's default? The following is a brief description of the basic rules concerning the recognition of gain or loss on the reacquisition of real property.

Generally, a seller, who has retained a security interest in the real property sold and then repossesses the property as a result of the buyer's default, cannot recognize a loss from the reacquisition. Nor can you, the seller, treat the debt secured by the property as worthless as a result of the repossession. In addition, gain on the reacquisition is limited to the money and fair market value of other property received by you to the extent that these amounts have not been reported in income. Gain is further limited to the amount realized from the original sale, reduced by amounts already reported in income and amounts paid by you in connection with the reacquisition of the property. Thus, the recognized gain is limited to the amount by which the sales price of the real property exceeds the property's adjusted basis (i.e., the gain on the original sale), less the amount of gain on the original sale that was reported as income before the reacquisition, and the amount of money and the fair market value of the other property paid or transferred by you in connection with the reacquisition.

After determining the amount of recognized repossession gain received, that gain must be characterized for tax treatment. The character assigned is based on whether the gain on the original sale was returned on the installment method or, if not, on whether the title to the real property was transferred to the purchaser. The repossession gain has the same nature as the gain reported on the original sale if it was reported on the installment method. If the title was transferred to the purchaser and you accepted a voluntary reconveyance of the property, i.e., a deferred payment sale, the gain is ordinary income. If, however, the purchaser's obligation was considered a "security," your resulting gain on the reacquisition is capital gain.

An additional issue that arises in the reacquisition of property involves the calculation of the property's new basis. The basis of your reacquired property is the adjusted basis of the buyer's debt to you, increased by any gain from the reacquisition, plus the amount of money and the fair market value of any other property you paid in connection with the reacquisition of the property. Note that if the property you reacquired was formerly your principal residence, and you did not recognize gain on the sale of such principal residence, then no gain or loss results from the reacquisition if you resell the repossessed property within one year.

The discussion above outlines the general rules governing the recognition of gain or loss on the reacquisition of real property. The correct tax treatment of a particular situation, however, can be made only after a careful examination of the facts and circumstances.
If you will be forced to repossess real property you have sold you should discuss the transaction with a real property tax attorney to examine more closely the circumstances surrounding your situation.

Withholding Obligations Upon Sale of Real Property by Foreign Person

When you purchase real property in the United States from a nonresident alien, generally, you have an obligation under the Internal Revenue Code to withhold a certain portion of your purchase price and pay it over to the IRS. The following summarizes the withholding rules applicable when a nonresident alien individual sells real property to a U.S. individual.

When Withholding is Required:

The Internal Revenue Code taxes gain (or loss) by a foreign person from the disposition of U.S. real property at regular rates. Furthermore, the Internal Revenue Code generally requires any buyer to withhold from the purchase price an amount which constitutes a tax on the foreign seller. The normal withholding rate is 10% of the amount realized by the seller on the disposition. The amount realized by the seller is the sum of the following:

  1. The cash paid, or to be paid (principal only),
  2. The fair market value of other property transferred, or to be transferred, and
  3. The outstanding amount of any liability assumed by the buyer or to which the property is subject immediately before and after the transfer.

Exceptions to the Requirement of Withholding:

Probably the most important exception, although it does not apply to you, is that a person who acquires property for use by him as a residence is not required to withhold tax if the total purchase price for the property does not exceed $300,000. In order to claim this exemption, you must have definite plans to reside at the residence for at least 50% of the number of days the property is in use during each of the first two 12-month periods following the date of the sale. There is also an exception to withholding if the seller furnishes to the buyer an affidavit stating, under penalty of perjury, that the transferor is not a foreign person and containing the seller's United States taxpayer identification number. You, as a buyer, may rely on this statement and will be relieved of the withholding obligation unless you have notice or knowledge that the nonforeign affidavit is false.

Furthermore, a transaction is exempt from withholding if you, the buyer, receive a "withholding certificate" from the IRS that excuses withholding. This certificate is discussed below.

Limitations on the Amount to be Withheld:

The amount required to be withheld in a transaction will not exceed the amount that the IRS determines to be the transferor's maximum tax liability. Either the buyer or the seller may request a determination of the transferor's maximum tax liability from the IRS. The seller may seek an early refund of any amount withheld in excess of the transferor's maximum tax liability.

The amount required to be withheld can be adjusted pursuant to a withholding certificate issued by the IRS. Either the buyer or the seller may request a withholding certificate. A withholding certificate may be issued as a result of:

  1. A determination by the IRS that reduced withholding is appropriate because either:
    • The amount required to be withheld would be more than the transferor's maximum tax liability, or
    • Withholding of the reduced amount would not jeopardize collection of tax,
      The exemption from U.S. tax of all gain realized by the seller, or
  2. An agreement for the payment of tax providing security for the tax liability, entered into by the buyer or the seller.

Reporting and Payment to the IRS:

You must report and pay to the IRS any tax withheld by the 20th day after the date of the sale. In reporting and paying the withheld amount the following forms are to be used: Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests by Foreign Persons of U.S. Real Property Interests; and Form 8288, A Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests.