Vacant land has long been viewed by many as an attractive investment. After all, it's the stuff they're not making any more of. You usually earn no income from vacant land, but you do have expenses for such items as property tax, interest, and other carrying costs. Can you deduct these costs? It depends.
First of all, for tax purposes there are two types of people who own vacant land: investors and real estate dealers. Real estate dealers are in the business of buying and selling land. A dealer buys property and resells it, usually at a price higher than the purchase price, and normally after only a short holding period. A good example is a subdivider who buys large tracts of vacant land, divides them into smaller lots, and then resells the lots piecemeal. Numerous and continuous sales over an extended time period are the hallmark of a real estate dealer.
Real estate dealers are entitled to the much the same deductions as any other business owner. They can deduct all the expenses of owning the vacant land they buy and sell, including interest, taxes, and other carrying costs. If you are a sole proprietor, these are deducted on IRS Schedule C.
On the down side, all the profits real estate dealers earn from their business are taxed at ordinary income rates instead of capital gains rates. Moreover, they must pay Social Security and Medicare taxes on their net self-employment income, as well as income tax. Also, real estate dealers are not allowed to take depreciation deductions. So if the land has structures on it, their cost cannot be deducted.
A person who purchases real estate as an investment is not in the business of buying and selling vacant land on a continuous and extended basis. Rather, he or she purchases land and usually holds on to it for some time in the hope that it will appreciate in value.
Since an investor is not engaged in a business, he or she is not entitled to business deductions and does not file Schedule C. However, many investment expenses are deductible as personal itemized deductions on Schedule A. These expenses are an ordinary tax deduction that results in tax benefits at your regular income tax rate, which can be as high as 39.6% (43.4% if you're subject to the new Medicare net investment income tax).
Any interest an investor pays on money borrowed to purchase vacant land is investment interest that can be deducted as an itemized personal deduction. However, the annual deduction for investment interest is limited to the investor's net investment income for the year. Any excess is carried over to future years. You determine the amount of your net investment income by subtracting your annual investment expenses (other than interest expenses) from your investment income.
Example: George purchases a vacant lot on which he pays annual property taxes of $1,000 and interest of $2,000. His only other investment is a savings account which earns $2,000 in annual interest. His net investment income is $1,000 ($2,000 interest income - $1,000 property tax expense = $1,000. Thus he may deduct only $1,000 of his interest expense. The excess $1,000 is carried over to future years.
An investor can also deduct property taxes paid on a vacant land as a personal itemized deduction on Schedule A. This deduction is not limited to the amount of net investment income.
Any other carrying costs such as legal and accounting fees, insurance, and travel expenses are also deductible on Schedule A. However, they are deductible only as miscellaneous itemized deductions. This means that they can be deducted only if, and to the extent, they exceed 2% of the taxpayer's adjusted gross income.
If you don't itemize your deductions on your tax return, you won't be able to deduct any of the expenses you incur from owning vacant land. In this event, you should elect to add these expenses to your land's cost basis. This will reduce any taxable profit you earn when you sell the property.
Example: Jean purchases a vacant lot for $10,000. Over the next four years she elects to add $5,000 in carrying costs to the lot's cost basis. At the end of that four years, her adjusted basis in the lot is $15,000. She sells the lot for $20,000. Her taxable gain is only $5,000 ($20,000 sales price - $15,000 adjusted basis = $5,000).
You must make an annual election to add these costs to your land's basis--"capitalize" them in tax jargon. You can elect to capitalize all your costs, or capitalize some and not others--for example, you could capitalize interest but not taxes.
To make this election you should add a statement like the following to your tax return:
"For tax year _____, taxpayer hereby elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize, rather than deduct, property taxes, mortgage interest, insurance expenses, and other miscellaneous carrying costs on the 111 First St. vacant lot."
You need to make this election each year you want to add these costs to your land's basis. If you wish, you can make the election some years you own the property, and not make it in others.