DEAR BENNY: I purchased 30 acres for $600,000 in 2004. This part of the county is zoned to a minimum parcel size of 10 acres. We recently built a home on one part of the property and reside there. At some future point 10-15 years from now, we may decide to sell off one or two 10-acre lots.
If I subdivided the property and sold off a 10-acre lot, what would be the tax consequences? Assume a sales price of $500,000 for a 10-acre lot. –Bill
DEAR BILL: This is a complex tax and accounting question and you really have to consult with a tax attorney and an accountant. But let me give you a brief, oversimplified answer.
When you own real estate — whether it is residential or investment property — and you hold it for at least one year, unless you qualify for the up-to-$500,000 (or $250,000) exclusion of gain, you will have to pay capital gains tax to the IRS and whatever appropriate state tax may be imposed.
However, when you start to sell real estate, depending on the facts of your particular situation, the IRS may consider you to be a "dealer," in which case you will have to pay the tax as if it were a short-term capital gain — in other words at the same tax rate that you pay on your ordinary income.
The difference can be very significant. For example, the current capital gains tax rate is 15 percent. But if you are considered a "dealer" you may have to pay the tax as high as 35 percent.
If you were to subdivide and sell off 10 units in one year, you are automatically considered a "dealer" and will have to pay the full tax. However, because you are going to sell only one lot, a strong argument can be made that you will have to pay only the then-current capital gains tax.
This issue has been widely litigated over the years, and the courts have looked at a number of issues that they will consider in making the determination of "dealer" versus "investor." Some of these factors include:
- Is the taxpayer in the business of selling real estate?
- Was the property listed with real estate agents?
- How long was the property held by the taxpayer before it was sold?
- What was the taxpayer’s initial objective when the land was purchased: to sell or hold?
- What did the taxpayer do to improve the property? For example, were improvements (such as infrastructure) made to the land?
Your tax advisor will analyze all of the factors and assist you in deciding what your tax implications will be.
DEAR BENNY: If a house sells for $100,000 with a 6 percent commission, is it illegal to record the purchase price of the house for $94,000 and pay the commission separately? –Kai
DEAR KAI: If you have a sales contract for $100,000, that’s the sales price. If you try to lower the price, you are defrauding both the buyer’s lender as well as the state or county real estate tax offices. Typically, any recordation or transfer tax that is paid to the government is based on the sales price, and in your example, these taxes would not reflect the true purchase and sales price. You are also misrepresenting the price to the IRS when you file your income tax return.
No, I don’t like this arrangement and cannot recommend it.
DEAR BENNY: We recently purchased a cabin in West Virginia and our deed says that we cannot rent the cabin. We agreed with that because we will use it for our family only. A similar cabin in our community stipulates the same leasing restriction, and the owners know this but still rent it.
Actually, that other owner’s family has a Web site offering the rental of the cabin. Isn’t this against the law? Who enforces the law regarding what is stated in your deed? If the person(s) offering the rental on the Web are certified Realtors, can they be brought before the board of Realtors?
What can we do to prevent this person from renting their cabin? The majority of owners in this community feel the way I do and bought property at this location for the serenity and beauty and not for it to turn into a popular rental resort. –George
DEAR GEORGE: If your property is in a community association, the board of directors of the association can enforce it.
If there is no such association, then I suggest that you get a number of your neighbors to join you in a lawsuit against that owner. A lawyer in your area should be able to assist you by filing a suit to enforce the terms of the deed, which in legal terms is called a "restrictive covenant."
The lawsuit would be asking the court to issue a declaratory judgment that the restriction is valid, and to further issue a restraining order against that owner.
You also raised an interesting issue. If there are real estate agents and brokers involved in renting, I would get a copy of the neighbor’s deed — it should be publically available from the local county office of the recorder of deeds — and send a copy to all real estate agents. I would warn them that they are involved in a transaction that is not permitted. Hopefully, that would get their attention.
DEAR BENNY: I have the opportunity to buy a fixer-upper for a seasonal rental near a ski resort in Vermont. The price is well below market value. The house has a new roof, but needs an updated bathroom, new carpet and paint, along with some other minor cosmetic fixes. I may choose to live there in the next few years. I have enough cash on hand to pay for the purchase and repairs. Would you still recommend financing? –Catherine
DEAR CATHERINE: This is always a difficult question to answer, and much depends on your own personal financial situation. You state that you have the money to buy the house and pay for the necessary repairs. But what about your other assets? The last thing you want to be — as you grow older — is to be "house rich and cash poor."
I am a strong believer the homeowners should have a mortgage on their properties. They get tax benefits from the mortgage interest that they pay, and can use that cash for other investments.
No, in most situations, it does not make sense to get a mortgage at 6 percent and put your money in a bank account that only pays you 3 percent.
But if you have the opportunity to invest your money elsewhere, why put all of your cash into that resort property.
You indicate that the property is below market value. Hopefully, in the foreseeable future, the real estate market will bounce back. Assuming that this investment will increase in value by just 3-5 percent a year, you will have dead equity in your house — doing nothing for you.
And keep in mind that under current tax law, you can deduct interest only on what is known as the "acquisition indebtedness" plus $100,000. If you pay all cash, your acquisition indebtedness is zero. So in the future, if you ever decide you want to refinance and pull out some of that equity, your tax deductions will be limited to the interest on only $100,000. This is yet another factor to consider as you ponder the question of whether to pay all cash.
DEAR BENNY: The question I have concerns the deed to our home. I married a man 24 years my senior who has three grown children, and his first wife died two years before we started seeing each other. He has changed the will to read that I receive the house and all contents, but his deceased wife’s name is still on the deed. Should we change the deed to both our names? –Stephanie
DEAR STEPHANIE: I don’t know where the house is, so I have to provide a general response. Community property laws may change my response.
First, you have to determine how title was held between your husband and his first wife. if, for example, it was not in tenants by the entirety (or joint tenants with rights of survivorship), then it is possible that the three children of the first wife have an interest in the house. And probate of the first wife’s estate may be necessary. You must consult with an attorney in your state to clarify this issue.
If, however, your husband is now the sole owner of the property and if he wants you to have the house on his death, then yes, your name should be added to the title in such a manner that you will automatically own the house on his death.
Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to [email protected].
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