DEFINITION of Section 1237 Capital Gain Opportunity

Section 1237 Capital Gain Opportunity is a specific tax credit that allows taxpayers to receive capital gains treatment on the sale of subdivided lots of land. The purpose is to allow individual taxpayers who are not real estate dealers to escape ordinary income tax treatment on the sale of a sublot of land.

BREAKING DOWN Section 1237 Capital Gain Opportunity

Section 1237 mandates that the lot cannot have had substantial improvements made to it, meaning any improvement that increases the value of the land by more than 10%. This includes buildings, roads and utilities of any kind. Furthermore, the property sold must have been held for at least five years (unless it was inherited), and neither it nor any other sublots can be held for sale to other customers during the year of sale.

Land And Income Taxes

Unimproved land isn't generally treated the same way as when you sell a property with a house that you've lived in. Under IRS rules, If your land includes a home and you lived there at least two of the five years before the sale, you can get a special capital gains tax exemption from ordinary income tax of your first $250,000 in profits ($500,000 if you are married filing jointly). 

For land that you don't live on, and you hold more than a year before selling it, any profits may be taxed at the maximum capital gains tax rates of 20% in 2017 (depending on your income) rather than ordinary income tax rates.  

If you subdivide the land and then sell a lot or lots, Section 1237 can save you a pile in taxes by applying the capital gains rate. But you must pass these tests:  You must indicate that you are not a real estate dealer or a C corporation. The land must be owned by you individually or jointly or indirectly via a partnership or LLC or S corporation

You must own the land for five years or more, or inherit the land. If it's a gift, you must assume the donor’s holding period as your holding period. The land must not have previously been held for sale to customers as dealer property. You can't make any “substantial improvements” that “substantially enhance” the value of the lots, although there are tests for this. 

There's a host of other rules, exceptions and limitations, which you can find in IRS Publication 544 and in section 1237 of the IRS Code.