Land Subdivision & Sale

Client purchased vacant land in 2020 and subdivided the land into three separate lots. Client built a home on one lot, sold another in 2022, and gifted the third to their daughter in same year. Client has also incurred about $23k in total costs to improve all three lots (prior to sale and gift), including putting in a road, running electrical wire, excavation, surveying costs, septic installation, etc.

The original purchase price is being allocated based on assessment values allocated to each parcel of land. However, not entirely certain whether assessed value should be used to allocate the improvement costs or whether acreage would be a better allocation method. So that’s question #1.

Even though these parcels of land were adjacent to the taxpayer’s home, because they are not selling their home within 2 years of selling this land, they do not qualify for Section 121 exclusion. So they’re undoubtedly going to need to report some type of taxable gain on the sale of this property.

But next issue is whether the gain on this property should be considered ordinary or capital in nature. They do not qualify for the Section 1237 safe harbor because they have not owned the land for 5 years or more AND they appear to have made substantial improvements to the property (since according to IRS regulations, substantial improvements include roads and electrical installation, etc.). So my 2nd question is, if they do not automatically meet the safe harbor to treat this as a capital gain, do the facts mentioned above make this gain subject to ordinary tax rates? If it’s based on facts and circumstances, this property does not appear to have been held for sale in the ordinary course of trade or business. They bought the property primarily to live on and NEEDED to improve the property for it to be in a livable condition. The other parcels just happened to benefit from these improvements. It just seems like now that this property does not automatically qualify for capital gain treatment, it’s left to interpretation and leaves an opportunity of risk that the IRS could eventually decide this to be ordinary in nature upon audit.

And last question, related to the gift. They did not intend to gift this property to their daughter but they were required to under a local family member exception rule in order to avoid certain zoning requirements. Their daughter must hold the lot for 3 years before she can gift it back. For gift tax return filing requirements, should we use the assessed value of this parcel as the gift amount? Is the assessed value sufficient here? Don’t file a lot of these types of returns so maybe this is a simple answer.

Is it really a gift, considering those conditions?

It's LTCG. 1237 is a safe harbor which is useful if there are a lot of sales. And unless someone has potential estate tax exposure, filing the 709 makes no difference unless it's helpful for some private reason. I agree with Nilodop that it doesn't sound like a gift, other than use of the property for three years.

They bought the property primarily to live on and NEEDED to improve the property for it to be in a livable condition.

But did they need to subdivide it? Just playing devil’s advocate.

And as to the gifted lot, if they didn’t plan on gifting the lot to the daughter, what was their original plan? I also don’t understand why mom and dad didn’t just keep the “daughter lot” in their own name. Zoning requirement is a bit unclear: If it’s okay for daughter to own the one lot, why couldn’t mom and dad?

Sorry for everyone who responded. I was not alerted that anyone had responded.

But did they need to subdivide it? Just playing devil’s advocate.

And as to the gifted lot, if they didn’t plan on gifting the lot to the daughter, what was their original plan? I also don’t understand why mom and dad didn’t just keep the “daughter lot” in their own name. Zoning requirement is a bit unclear: If it’s okay for daughter to own the one lot, why couldn’t mom and dad?

To answer your question for the purpose of the “gift”, there is a family member exception in the county to the normal subdivision regulations allowing property owners to create lots that have no road frontage. The county requires that the lot have at least 50 feet of road frontage on a public street. If that cannot be met, the individual can convey the lot to an immediate family member, but the family member must hold the lot for a minimum of three years.

So the gift was made primarily to get around this road requirement. So they gifted the lot to their daughter. Although they intend to have the daughter gift the land back to them after the three years, she holds legal title to the property and can keep it if she decides. Legally, the land is hers to possess indefinitely. Therefore, would this not require a gift tax return?

It's LTCG. 1237 is a safe harbor which is useful if there are a lot of sales. And unless someone has potential estate tax exposure, filing the 709 makes no difference unless it's helpful for some private reason. I agree with Nilodop that it doesn't sound like a gift, other than use of the property for three years.

I believe this should be treated as LTCG as well just based the facts in this case. Just wasn’t sure if it HAD to meet 1237 to qualify. Regarding the gift, no eventual estate tax exposure but the instructions to the Form 709 don’t specifically exclude someone from filing the form simply because they won’t eventually be exposed to estate tax. And also, even though it doesn’t really sound like a true gift, just based on the situation, doesn’t automatically exclude it from gift tax return filing, correct? If legal title has transferred to the daughter and she has full rights to do what she wants with that property, would that not be considered a gift in the eyes of the IRS?

I have a somewhat similar situation where a client purchased a lot with the intention of improving and building a prefab house on it. That didn't happen and they sold it last year (owned it about 15 months). What form is that reported on? I have a 1099. If I report on 4797, it's ordinary income. I think it should be reported as a capital gain.

Without researching this in great detail, this sounds like LTCG treatment as well, if they’re not buying and selling land regularly within the ordinary course of a trade or business. So this would go on Schedule D.

Your clients say it was a gift, although there is an expectation of a gift back. Expectation is not an agreement. So technically a 709 is required. As a practical matter there is no downside from not filing it. But the 709 filing could matter for purposes of the local authorities, so I'd suggest filing it.