IRS regulations specifically allow you to use the federal income tax home-sale gain exclusion privilege to shelter profit from selling vacant land adjacent to your house -- even if the land sale occurs in one or more transactions that are completely separate from the sale of your house. Although this sounds too good to be true, it is true!
Gain Exclusion Qualification Rules
If you're unmarried, you can potentially sell your principal residence for a gain of up to $250,000 without owing anything to the U.S. Treasury. If you're married and file jointly, you can potentially exclude up to $500,000 of home sale gain. To qualify, you generally must pass both of the following tests:
1. You must have owned the property for at least two years during the five-year period ending on the sale date (the ownership test).
2. You must have used the property as a principal residence for at least two years during the same five-year period (the use test).
To be eligible for the $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.
If you excluded a gain from an earlier principal residence sale under these rules, you generally must wait at least two years before taking advantage of the break again. For joint filers, the $500,000 exclusion is only available when both you and your spouse have not claimed an exclusion for an earlier sale within two years of the sale date in question.
Capital gains in excess of your exclusion are generally taxed at a maximum federal rate of no more than 20 percent. The 20 percent rate only affects singles with taxable income above $400,000, married joint-filing couples with income above $450,000, heads of households with income above $425,000, and married individuals who file separate returns with income above $225,000. Capital gains on investments held less than a year are short-term capital gains and taxed at ordinary income tax rates of 10, 15, 25, 28, 33, 35 or 39.6% in 2017 (and 2016).
State tax may also apply.
To take advantage of this break, however, there are some restrictions:
- The land must be adjacent to the parcel that contains your house, and it must be used as part of your principal residence (as opposed to being used for business or rental purposes).
- The house must also be used as your principal residence.
- The adjacent land must be sold within two years before or after the sale of the parcel that contains your house, and you must meet certain timing requirements for both the sale of the house and the sale, or sales, of the land. (See right-hand box for timing qualifications.)
Assuming you pass all the tests, you can use whichever gain exclusion amount applies ($250,000 for single filers or $500,000 for joint filers) to shelter from federal (and sometimes state) capital gains tax the combined profit from selling the parcel containing your house and the adjacent land.
How Much Land Can You Sell?
Based on an example in the IRS regulations, you could sell at least 29 acres without being challenged by the government (maybe more because there are no specific guidelines for the amount of land that can be considered part and parcel of your principal residence).
What happens when the adjacent land is sold in a year before or after the year you sell the parcel containing your house? If you sell the parcel with your house after the due date of the return for the earlier year when the land was sold, you must report the land sale gain on your Schedule D (your gain equals the difference between the sale price for the land and your tax basis in that part of the property).
After you've completed the sale of the parcel that contains your house, you file an amended return on Form 1040X to use part of your gain exclusion (up to $250,000 or $500,000 if you file jointly) to shelter all or part of the profit from the land sale. You will then be due a tax refund for the year of the land sale.
If you sell the parcel with your house before the due date of the return for the preceding year when the land was sold, simply use part of your gain exclusion to shelter all or part of the land sale gain on the earlier year's return. In the later year, you can use your remaining gain exclusion to shelter all or part of the profit from selling the parcel that contains your house.
Your tax adviser can help you take advantage of the home sale gain exclusion for sales of land next to your house. Advance planning may be necessary to maximize your tax savings.
