- 1 acre of land is purchased for $100,000.
- The 1 acre is subdivided into 3 lots. 1 lot is .5 acre and the other
two lots are .25 acre.
- The two .25 acre lots are thing sold for $45,000 each for a total of $90,000.
- The .5 acre lot is retained for personal use

In the above scenario is there any capital gains?  
Why or why not?  
How much is the capital gain and what would the tax on that gain be?

Hello and thank you for your question.

According to the IRS, "[i]f you own a tract of land and, to sell or
exchange it, you subdivide it into individual lots or parcels, the
gain normally is ordinary income. However, you may receive capital
gain treatment on at least part of the proceeds provided you meet
certain requirements. See section 1237 of the Internal Revenue Code."
http://www.irs.gov/publications/p544/ch02.html

Here's a summary of the Section 1237 exception:
"In limited circumstances, [Sec. 1237] allows long-term capital gain
treatment when land held for investment is subdivided into lots. To
qualify for IRC 1237 all of these requirements will have to be met.

1. A C corporation cannot own the land.

2. The land is one tract of land. Other tracts can be owned, but not
be for sale simultaneously with the tract trying to be qualified.

3. The land had not previously been for sale in the ordinary course of
your trade or business. If you had previously held it for sale under
IRC 1237, it is eligible for consideration.

4. No Substantial improvements have been made, or as part of the sale,
agreed to be made.

5. You have held the property for at least 5 years or received the
property through inheritance.

6. No other real estate can have been held by you for sale to
customers in the year of sale.

Per IRC 1237, the term 'tract of real property' means a single piece
of real property, except 2 or more pieces of real property shall be
considered a tract if at any time they were contiguous in the hand of
the taxpayer or if they would be contiguous in the hand of the
taxpayer except for the interposition of a road, street, railroad,
stream, or similar property."
http://www.avz.com/pages/article16.htm

So in your example, if you purchased the land at least 5 years ago (or
inherited it), you'll qualify for capital gains.

As for the amount of the gain, the two .25 acre lots account for 50%
of the 100,000 cost basis, i.e. 50,000.  So the capital gain would be
90,000 - 50,000 = 40,000 [if the Sec 1237 requrements are met].

Search terms used:
subdivide capital site:irs.gov
"section 1237" capital 

Thanks again for letting us help.
Richard-ga

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Request for Answer Clarification by chadhen-ga on 20 Jul 2005 06:42 PDT

I do not qualify for Section 1237 so I would pay tax on $40,000 as
ordinary income.  Is that correct?

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Clarification of Answer by richard-ga on 20 Jul 2005 09:49 PDT

Hello again.

Certainly the IRS wants ordinary income from the subdivision, which
means every dollar of the $90,000 would be taxable.  And in this area,
the word "subdivide" is generally poison, which is why they enacted
the section 1237 exception to protect casual subdividers.

But really it's a question of fact - - whether
*you held the lots primarily for sale to customers in the ordinary
course of a trade or business as a developer of real estate (ordinary
income and no basis allowed) or
*you didn't hold the lots primarily for sale to customers in the
ordinary course of a trade or business (capital gain and basis
allowed).

Here's a very good article on the subject--if you think the particular
facts are enough on your side you might consider reporting a capital
gain, and disclose on your return why you're taking that position.
Understanding dealer status on the sale of real estate
Taxes,  Oct 2002  by Swad, Randy
http://www.findarticles.com/p/articles/mi_qa3663/is_200210/ai_n9116428

-R

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Clarification of Answer by richard-ga on 20 Jul 2005 09:54 PDT

My typing error - - you get basis in either case, so yes, either it's
40,000 of ordinary income or it's 40,000 of capital gain.
Sorry for the confusion.

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Clarification of Answer by richard-ga on 20 Jul 2005 09:56 PDT

http://www.irs.gov/publications/p551/ar02.html

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Request for Answer Clarification by chadhen-ga on 20 Jul 2005 13:20 PDT

I appreciate your thorough advice.  This is definitely a unique
situation for me.  I know I don?t qualify for Section 1237 because I
have not held the property for more than 5 years or inherited it.  I
am simply doing the transaction to obtain and offset the cost of the
retained .5 acre lot to build my primary resident on.  So according to
section 1221 I am not really a dealer since the property was not held
primarily for sale to customers in the ordinary course of my trade or
business (I am employeed with a large telephone company).  Or at least
that is how I interpret it.  Since I haven?t actually done this yet,
does the IRS provide findings on these issues if asked in advanced,
outside of the normal return?

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Clarification of Answer by richard-ga on 20 Jul 2005 14:52 PDT

There is a process called a private letter ruling, but where as here
it's a question of fact rather than a question of what the law is, you
won't get a ruling from the IRS.   If you want to take the capital
gain position on your tax return I suggest you have a CPA prepare it,
and do disclose your basis for reporting it that way (so as to reduce
the risk of penalties if the IRS challenges it).
Thank you for the generous rating and tip.
Richard-ga

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Clarification of Answer by richard-ga on 20 Jul 2005 14:53 PDT

And by the way, you must have owned the land for one year or you won't
have the holding period for long term capital gain treatment anyway. 
A short term capital gain in most cases will cost you the same as
ordinary income!
-R