The gain on sale of land that is held primarily for sale to customers in the ordinary course of business is taxable at ordinary income rates (and not at the more favorable capital gains rates).  In addition, those gains may be subject to self-employment tax.  The prospective increase in sale value from subdivision can suddenly become much less attractive given the increased tax burden.  Persons holding land for sale as described above are known as “dealers.”  Whether you are a dealer depends on the number of factors, including the purpose for which you acquired and subsequently held the property, the extent of improvements you make to the property, the frequency and number of sales and the extent of your efforts to sell the property. 

As you can see from this list of considerations, subdividing a parcel into multiple lots for sale could give rise to the owner being characterized as a dealer and taxed as ordinary income rates on any sale gain.  The tax code provides some relief for these situations in section 1237. Under that section, ordinary income treatment will not apply if the land was not previously held for sale, if the improvements are not substantial and the property has been held for at least five years.  Improvements such as surveying, filling, draining, leveling and clearing are not substantial.  Permanent structures and paved roads are substantial.  If you meet those three requirements, gain on the sale of up to five lots will be taxable as capital gain.  If you sell six or more lots within the same tax year, then 5% of the sales price (less sales expenses) will be taxable as ordinary income and the remainder is taxable as capital gain.

Bottom Line:  By tailoring your subdivision transaction to the requirements of Section 1237, you have a better chance of preserving capital gain treatment on the sale of parcels resulting from subdivision. Note that the foregoing is a very high-level description and a more thorough analysis of section 1237 should be undertaken in connection with any transaction.

“Back in my day, there was so much toilet paper and so many eggs that we gathered at night and threw them at the houses of our enemies.”  – Any baby boomer.