Selling Combined Lots? What are the Tax Implications. Figuring out the Cost Basis and Capital Gains on the Properties
By Ilyce Glink and Samuel J. Tamkin
Q: We have two combined lots that we bought in 1984 for a total cost of about $50,000. A 100-year old cottage sits on one lot and the other lot is a landscaped garden with no structures. Over the past 37 years, we have spent quite a bit of money on landscaping, fencing, a new roof, a new garage and a complete gut job to the main floor and attic of the house.
We have been offered over a million dollars for the combined properties. A buyer will likely tear our house down and build one mega-mansion across the two properties. We are moving to a senior community. What kind of taxes are we facing? There is a rumor of a one-time $500,000 break on taxes, but is that just on the house?
Selling Combined Lots? What are the Tax Implications
A: The great news for you is that the “rumor” is true. If you are married, own a home and use it as your primary residence for at least two out of the last five years, you get to exclude $500,000 of profit from federal income taxes. Singles get to exclude up to $250,000 in profit.
More good news: under current federal tax law, you can take this exclusion every 24 months, so long as you live in the property for 2 out of the last 5 years as your primary residence. (There are a few other limitations that you’d expect from the Internal Revenue Service, and rules that cover a scenario where you might have lived in the home as your primary residence for only 18 months instead of 24.)
Of course, that won’t quite cover your expected profit, but we’ll get to how you calculate that in a moment.
The interesting variation in your question is that you have two combined lots. If the two lots were (and continue to be) used as a single property, we think you should be able to claim that the entire property was your primary residence.
If the original lot had the house and the second lot was purchased to provide a side or back yard, you could take the position that both lots comprised your home even if you could have sold the vacant lot to a different person. We say that, but if you filed income tax returns and treated the lot as an investment property over the years, you might have to allocate your profits between your primary residence and the vacant lot (that functions as your side yard).
Cost Basis of the Properties
Let’s look at how much you’ll owe, if anything, since you put quite a bit of money into major improvements over the years. While you didn’t give us any details, it’s hard to imagine a gut rehab would cost less than $200,000. We’ll assume that amount, plus the $50,000 you spent to buy the property. The Internal Revenue Service counts both of these towards your basis into the home.
“Basis” is the term the IRS uses for what most of us would think of as the amount of money we’ve sunk into the property to buy it and then to complete any structural or material improvements, including the new roof, major remodeling, an addition, the new garage, new electrical or plumbing, etc. Basis also includes the cost to buy or sell the home. For more information on what goes into your basis, you can look at the IRS publication 523 at www.IRS.gov. (https://www.irs.gov/forms-pubs/about-publication-523)
Figuring out the Capital Gains on the Properties
If we assume that the basis is $250,000 and you’re now going to sell the home for $1,000,000, you’ll have $750,000 in profit. The IRS would not tax you on the first $500,000 (as you are married) but the IRS would tax you on the balance of the profit of $250,000.
Under current tax law, you’d pay capital gains taxes of 20 percent plus the Net Investment Income Tax of 3.8 percent for a total of 23.8% tax or $59,500 on the $250,000 in profits. Of course there may be other factors in your tax return that will change these numbers and you may have state and local income taxes to pay depending on where you live, but this will give you a general idea of what to expect.
Can you reduce that $250,000 in profits further? This would be a good time for you to sit down and go through the cash you’ve put into the home over the years and figure out what you can and can’t include into the “basis” of the home. Don’t forget the cost of buying the home (including closing costs that you may be permitted to add to the basis) and the cost of sale. IRS Publication 523 has a good list and descriptions and includes excellent (and realistic) examples of what you can and can’t include in computing the basis for your home.
Splitting the Lot and Home into Two Transactions
One final note: If for some reason you have to split the lot and the home and can’t take the exclusion on the lot, it may not matter in the end. You’d have to treat the purchase of the home and one transaction and the purchase of the lot as a second transaction. Likewise, when you sell, you’d treat the sale of the home as one deal and the lot as a second one. You’d have to allocate a price to the lot with the house and a price to the lot alone.
For example, you might find out that the basis for the lot was $10,000 and the home $40,000. Upon the sale, you might be able to allocate $900,000 towards the sale of the home and $100,000 towards the sale of the lot. In this scenario, you’d end up in about the same place financially as in our prior example.
How you allocate the cash is important. If, for some reason, you allocated $500,000 to the sale of the home and $500,000 to the sale of the lot, you’d pay no taxes on the sale of the home but would have a $490,000 profit on the sale of the lot so instead of paying capital gains and the 3.8% Net Investment Income Tax on $250,000, you pay it on $490,000. Obviously, the IRS would get a larger portion of that check.
You don’t know what you don’t know. So, spend a little time with your accountant or tax preparer to make sure you understand your options and compute the taxes on the sale correctly. Congratulations on this windfall.
©2021 by Ilyce Glink and Samuel J. Tamkin.