Where properties go, taxes follow. Understanding the tax implications becomes paramount once you've secured a land loan. This article offers a comprehensive overview of the tax implications associated with land loans as well as deductible implications and provides actionable strategies to minimize estate tax burdens to help you make informed decisions on your land loan journey.
After reading this article, make sure to check out Canopy’s article Land Loans: Everything You Need To Know > Canopy CU for more helpful information
What Are the Tax Implications of Land Loans
Once you've closed on a land loan, you may wonder, "How will this impact my taxes?" The effect on your taxes will depend on your planned use of your land:
- If you plan to build on the land: You can be eligible for tax exemption as your land loan will eventually transition to a construction loan.
- If you plan to farm on it and it’s identified as agricultural land: You can receive a large tax break through agricultural exemption, depending on state and local tax laws.
- If you plan to wait for the land’s value to appreciate: You can be taxed for investment expenses.
Because this article explores the tax implications of land loans, we focus on the tax implications of purchasing vacant land for speculative investment.
Tax Implications of Land Loans: Types of Deduction and Other Advantages
We recommend consulting a tax professional. A certified accountant or tax attorney can help you navigate the tax laws of your land's location based on your circumstances. Meanwhile, here are general tax benefits property investors can utilize to maximize tax savings.
Property Taxes
Property taxes apply to all land investments. Vacant lands often have lower property values and, therefore, lower property taxes. Land investors can deduct property tax by listing them as an itemized personal deduction on Schedule A.
Mortgage Interest Deductions
When it comes to holding onto land for appreciation, landowners can leverage mortgage interest deductions to reduce their taxable income. This deduction allows them to subtract their annual mortgage interest payments from their annual net investment income.
For instance, let's consider Frank, who recently purchased an undeveloped property. Annually, his mortgage payment amounts to $1,000, and he also incurs property taxes totaling $500. Additionally, he earns $1,000 yearly from his investment portfolio. By deducting the property tax from his investment income ($1,000 - $500), Frank's net investment income stands at $500.
Consequently, he can deduct only $500 of his mortgage payment expense for the year, with the excess $500 carrying over to future tax years.
Depreciation Deductions
Owners of vacant land can claim depreciation of their property as an expense and reduce taxable income. While the land itself cannot depreciate, the improvements made by landowners can.
These improvements include installing outdoor lighting, paving parking spaces, and other structures that make the land usable. These improvements enable landowners to claim depreciation expenses, reducing their taxable income.
It's worth noting that land depreciation can also occur due to natural or human-induced events, like typhoons affecting the area or the discontinuation of a nearby highway.
No FICA Taxes
Income from real estate investments, including an increase in value, is exempt from FICA taxes.
FICA taxes encompass Social Security and Medicare taxes deducted from a person's paycheck as contributions to these programs. However, income generated from real estate investments is exempt from these deductions, offering property investors a tax advantage over regular employment income.
Tax Implications of Land Loans: Non-Deductibles and Other Liabilities
Here are tax implications that are the taxpayer’s obligations when they have a land loan.
Expenses that are Not Deductible
Due to the Tax Cuts and Jobs Act (TCJA), miscellaneous itemized deductions are no longer deductible. These deductions include unreimbursed job expenses, investment fees (excluding investment interest), and tax preparation fees. While they were once deductible above 2% of a taxpayer's adjusted gross income, TCJA has suspended them from 2018 through 2025.
Capital Gains Taxes from Property Sale
Capital gains are the profits you earn after selling an asset like a plot of land. When taxed, the exact rate is based on the asset's original price and when you have bought it. Here are the types of capital gains taxes.
- Short-term Capital Gains Taxes: Short-term capital gains are profits earned after selling an asset you owned for a year or less. Their tax rates can range from 0% to 37%.
- Long-term Capital Gains Taxes: Long-term capital gains are profits earned after selling an asset you owned for over a year. Their tax rates can range from 0% to 20%
How to Lower Your Income Taxes
Here are some potential ways to maximize profits.
How to Delay or Avoid Capital Gains Taxes on Land Loans
Capital gains taxes can be high, but there are options to help you avoid or delay these tax consequences.
1031 Exchange
This process allows you to immediately keep the proceeds from selling your property by investing it in another similar asset without paying capital gains taxes.
Delayed Sale
Since the rate of capital gains tax is affected by the date of the sale, a landowner can delay paying said tax by pushing the sale date into another tax year with a lower taxable income.
Donate the Land to Charity
Donating property can help you avoid capital gains tax when you want to give away land and avoid paying high tax rates.
How to Reduce Capital Gains Taxes on Land Loans
Here are ways to minimize capital gains tax rates.
Installment Sale
In this process, the buyer buys a portion of the property over several years until full ownership is transferred. This process can lower tax liabilities by spreading the taxable income across multiple sales.
Offset Gains with Losses
Utilize losses to offset capital gains and thereby reduce overall tax obligations. Short-term losses from assets can counterbalance short-term capital gains, while long-term losses can offset long-term ones.
Work with Estate Tax and Lending Experts
Collaborating with knowledgeable professionals is crucial for developing a comprehensive tax strategy to minimize liabilities. Consider partnering with the following experts:
- Real Estate Loan Officer: Seek guidance from a seasoned mortgage loan officer specializing in land loans. Lender officers can provide valuable insights into structuring your loan to optimize tax benefits. To connect with Canopy’s real estate team, log on to: Spokane Home Loans | Finance or Refinance Your Home Today (canopycu.com)
- Certified Accountant: Consult an accredited accountant to ensure the accuracy of your financial records and maximize tax deductions. Their expertise helps you navigate complex tax regulations and identify opportunities for tax savings.
- Tax Attorney: Consult a qualified tax attorney to stay informed about property tax laws specific to your location. They offer personalized advice for your circumstances, ensure compliance with current regulations, and potentially identify additional tax-saving strategies.
Empowering Borrowers with Informed Land Loan Decisions
Land loans have a lot of tax implications, both advantages and liabilities. But with the guidance of trusted experts, borrowers can craft personalized tax plans to maximize investment profits while minimizing tax burdens.
Looking for a loan officer or financial coach in Spokane? Contact us today to help you achieve smarter tax management for your land loan.