Vermont’s Land Gains Tax
Posted on Jun 30, 2011
(This article was first published in Vermont Property Owners Report, a Montpelier-based subscription newsletter about Vermont and Vermont real estate. Phone: 802.229.2433)
The Vermont land gains tax is imposed on gains attributable to the sale of land held for less than six years. Because the purpose of the tax is to inhibit land speculation, there are numerous exemptions to the law to make it better fit the legislative purpose. As a result, compliance with the administration of this tax can be time-consuming and expensive. We have found that our clients can save a great deal of money, both in taxes and in professional fees, by coming to this process prepared. This article will describe the tax and the exemptions to it. It will then address those steps that you should take over the course of your property ownership in order to reduce or eliminate your liability for land gains tax with the least amount of expense or headache.
The major exemptions are the following:
1. Buildings. The tax only applies to land. If you own a building but not the land it sits on, you are not liable for the tax.
2. Sunset. The tax does not apply to property held for longer than six years. As will be discussed in greater detail below, the tax rate is variable depending on (a) gain as a percentage of basis, and (b) holding period. The longer you have held the property, the lower the tax. After six years, no tax is due.
3. Leases. Most land leases are exempt, but the tax does apply to leases of 50 years or more, and certain other lease rights. If you have a concern about a lease arrangement, consult a professional.
4. Principal Residences. This is a common but complicated exemption.
a. An exemption may be claimed if the property is used as a principal residence by the seller or the buyer.
b. The exemption applies to sales of up to 10 acres of land, or up to 25 acres if required by a local zoning ordinance.
c. If the buyers are claiming the exemption, they must occupy the property as a principal residence within one year.
d. If raw land is being sold, a purchaser may still claim the exemption if a home will be built and occupied within two years.
5. Spec Houses. Purchasers who intend to build and sell principal residences may also claim exemptions. The acreage limitations are the same (No. 4, above). The construction must begin within one year of purchase and be completed within two years. The sale must take place within three years. The builder must also file Certificates of Principal Residence Construction.
6. Gifts. Transfers without payment are exempt.
7. Nonprofits. Certain sales involving government entities and/or non-profit organizations are exempt.
a. Farmers can sell farm property to family members without being subject to the tax if seller and buyer use the land for farming for a total of six years. The exemption is subject to definitional restrictions, and is not likely to apply to “hobby” or “gentleman’s” farms.
b. Sales of 25 acres or less to a farmer for active and direct use by that farmer may also be exempt, subject to certain definitional restrictions.
Land being a scarce commodity, we expect it to appreciate over time. The recent real estate bubble notwithstanding, we expect land to begin appreciating again in the future. In Vermont, it is a rare occurrence to experience a substantial gain on land in a period of six years, however. Unless a highway is built through the area or a man-made lake is suddenly lapping at your property line, your gains are likely to be modest.
In the cases that we have seen, substantial gains to investment most often are realized by new construction or by improving existing buildings. More realistically, the difference between what a client paid for a piece of property and what they are selling it for may not be an economic gain at all, given the amount of money they have expended improving the property. Selling price alone is not proof of economic gain or taxable gain. Nevertheless, your job with respect to Vermont land gains tax is to prove to the Vermont Department of Taxes how much your land has appreciated in value, if at all.
How It Works
In order to prepare for this tax, it is important to understand how the tax is administered. As one might imagine, it is very difficult to determine how much of the gain on a sale of a building with land is attributable solely to the land component.
The Tax Department allows taxpayers two possible methods for demonstrating how much gain is realized. The first is to obtain an appraisal. Appraisers are trained to make evaluations that consider numerous factors, including how much of your property’s value is attributable to your location. Obtaining an appraisal requires some advance planning, of course. It may also be costly, although the cost must be considered relative to the value of the property and the potential tax savings.
Even if you do obtain an appraisal, however, the Tax Department is not required to accept it. If they believe it to be worthwhile, they will obtain their own appraisal, and you will then be subject to a hearing in which a Department-appointed hearing officer considers the merits and demerits of the competing appraisals.
This is not an unusual feature of administrative law, but the presumptions tend to favor the Tax Department at this stage. If you lose at the hearing level, you may then appeal to superior court. The cost in time and fees may exceed the ultimate tax savings, especially considering that the Tax Department is both a party to the case and the judge at the first level hearing.
The second method of establishing gain attributable to land is to determine how much gain you have realized on the whole transaction and allocate a certain percentage to the land. There are two methods of doing this. First, you may look to the town Lister’s card that should have a valuation of your property broken down between land and improvements. You then determine what percentage of the overall value is represented by the land. That percentage is then applied to the gain on the sale transaction to determine how much gain is attributable to land.
This method is rather handy, but it is not always accurate. For example, it will not capture improvements made to a building since the last town appraisal. Even more problematic is the possibility that the town does not keep records with value broken down between land and buildings. This renders the Lister’s card useless for the purpose of calculating land gains tax.
The town may provide an underlying appraisal report with a cost analysis, but even that report will concede that the cost method of valuation will be wildly inaccurate for the purpose of valuing the property. Listers’ practices and records vary widely from one town to the next.
In the event that no other method is available, the Tax Department has issued an administrative guidance document that, among other things, provides default percentages that a taxpayer may use to allocate a share of overall gain to land. In most cases this figure will be 25%.
Once you have determined the taxable gain, the tax rate will be a function of holding period and gain as a percentage of basis. When gain is less than 100% of basis, the tax rate will range from 5% to 60%, depending on the holding period.
The land gains tax is a flat tax rather than a marginal tax like the income tax. That means the highest applicable tax applies to the entire gain.
Here are some examples to demonstrate the effects of gain and holding period on the rate and size of the tax. Where homes are included, assume they are vacation homes (the land gains tax does not apply to most sales where the property is the primary residence of the seller or will be of the buyer).
Example #1. Home and land is purchased by a couple for $200,000. After an “extreme home makeover,” the vacation home is sold three months later for $600,000. The couple elects to accept the Tax Department’s 25% allocation of gain to land. Without accounting for basis adjustments, these facts will result in an 80% tax on the 25% of the $400,000 gain that is attributable to land, for a total tax of 80% x ($400,000 x 25%): $80,000.
Example #2. Home is purchased for $200,000, and resold after 5 1/2 years for $600,000. The lister’s card indicates land is 20% of the overall value. The 20% of the $400,000 gain is taxed at a rate of 10%, for a total tax of $8,000. While dramatically less than $80,000, this amount of tax will come as a shock to the unsuspecting, particularly if it could have been avoided by proving a higher basis (thereby reducing the computed gain) or, in this case, simply by waiting another six months.
Example #3. A parcel of land is purchased for $300,000 and is resold in three years for $400,000. This scenario will result in a 15% tax on the $100,000 gain, or $15,000.
There is one other important detail with respect to the administration of this tax: the buyer is subject to a withholding requirement. The law states that the buyer must withhold 10% of the total purchase price, unless the seller proves the sale is exempt or he can get permission from the Tax Department to withhold less.
This permission to withhold less must be obtained in advance of closing in the form of a commissioner’s certificate. If you do not obtain a commissioner’s certificate, the buyer will be required to withhold an amount that is likely to be well in excess of the actual tax that will ultimately be due. As a seller, you then must submit a final land gains tax return within 30 days of closing and request a refund.
In our experience, the Department may take substantial time to act on your refund request. If a refund claim is denied, the Department is supposed to give you a hearing on the refund request. In any event, the Department is required to act on the refund claim within six months.
If the Department fails to issue a refund, but does not give you a hearing within six months, then the refund request is deemed to be denied and you may appeal to superior court. As you can see, this procedure can cause substantial delay.
Seeking a commissioner’s certificate prior to closing on the sale accelerates this procedure by forcing the seller and the Tax Department to do most of the work that would be required to submit and process a final return. The seller will request an amount that they believe to be appropriate. The Tax Department will do enough due diligence to protect its interest in securing an adequate withholding. Generally, the Tax Department has every incentive to seek from the seller whatever information it would need for an audit.
You are going to have to do the same amount of work either before or after closing. The difference is that by doing it before closing you will get your money into your pocket much more quickly.
As you can see, the seller of property subject to the tax would be wise to seek a commissioner’s certificate. Unfortunately, the land gains tax is often the last thing on a seller’s mind. Clients frequently come to us after a purchase and sale agreement is signed, which is not ideal.
While aware of the Vermont income tax on real property gains, sellers are frequently surprised to learn of the existence and nature of the land gains tax. They often do not have the information needed to complete a land gains tax return accurately and minimize their tax liability. The result is a combination of panic and increased expense. The client essentially pays us for our time gathering information that he or she could have marshalled in advance of the sale contract.
If you obtain appraisals for the value of the land on acquisition and upon its sale, the preparation of the tax return is quite simple. The Tax Department tends to distrust appraisals, however, and a hearing is almost guaranteed. In most cases, clients will rely on the Listers’ cards or the default percentage allocations allowed by the Tax Department (described in Part 1 in the last issue).
Under either of these latter two methods, it is necessary to calculate the overall gain on the transaction. The practical result of this is rather awkward: we generally find ourselves poring over records related to expenses incurred to make improvements on buildings in order to calculate the overall gain that is then apportioned between land and building.
If you cannot provide proof of such additions to basis, the land gains tax burden will be increased, even though the cost of the improvements arguably has no relationship to the question of the amount of gain on the land. Therefore, if you might sell land within six years that is not exempt from the tax, it is crucial that you maintain these records over the course of your ownership of the property and be prepared to itemize and supply them when it comes time to sell your property.
In order to obtain a commissioner’s certificate to reduce the 10% withholding on the sale of your Vermont property, attorneys need the following information:
1. A copy of the property transfer tax return from your purchase of the property. This return establishes the purchase price of the property for the purpose of calculating basis, and some additions to basis (e.g., transfer tax). The HUD-1 also is useful. It shows your legal fees for the acquisition.
2. The purchase and sale contract for the sale of your property. This document, together with the accompanying property transfer tax return for the sale, establishes the selling price of the property. The purchase and sale contract is relevant because the buyer files a form LG-1 reporting the gross sales price and the 10% withholding. Remember that for purposes of the land gains tax return (LG-2), you must show the amount of gain attributable to land.
If you are including personal property in the sale price (e.g., furniture), you need to indicate this in the purchase and sale contract and on the property transfer tax return. Often, no attention is paid to this issue in the contract, which is typically the form provided by real estate agents. Even if there is a space on the form to indicate the inclusion and value of personal property, sellers often do not concern themselves with this detail.
If you do not itemize in the contract, however, you (or your attorney) will have a very difficult time arguing to the Tax Department that the number you placed on the property transfer tax return as the price of real property is, in fact, the price of both real and personal property. You will end up showing an inflated overall gain on real property, a portion of which will then be allocated to the land, which is then reflected in a higher tax. When clients don’t think about this, the issue is often out of our hands by the time they come through our door.
3. Any and all records related to improvements on the property. These may include:
a. Receipts. If the receipt does not on its face establish a connection to the property being sold, be prepared to explain it. Be prepared for questions regarding who made the expenditure or why any expenditures were made out of state. If no sales tax was paid, Vermont is entitled to collect its 6% use tax. Buying in New Hampshire may not save you money.
b. Invoices. In lieu of a receipt, an invoice, preferably marked “paid,” is usually sufficient. Again, be sure that there is a connection drawn between the expenditure and the property.
c. Cancelled checks. These are also good evidence of payment. Be prepared to explain what the payment was for. Also, if you use an out-of-state checking account, be prepared to explain that as well. The explanation may be simple, but the tax examiner needs to know that the money was spent for improvements on the Vermont property and not for your hot tub at your out-of-state house.
d. Evidence of wages. If you work on your own property, you cannot add the value of your labor to your basis in that property. If, however, you own a contracting business and you redeploy your employees to work on your property, you can include the cost of their labor.
e. Credit card statements. These statements can also be evidence of expenditures related to the property. Again, you must be able to demonstrate or explain the connection. You should highlight those items on the statement that are includable.
f. Permits and professional fees. If you had to obtain permits or licenses, the amounts paid for fees or professional services are includable in your basis. The same is true of architectural fees.
g. Narrative. With respect to all of the above items that are not otherwise clear, an explanatory narrative from you will help.
h. Spreadsheet. If you can, categorize your additions to basis and add them up. Be sure these match what you have for supporting evidence. If not, you will end up paying more in professional fees to piece it all together, and the state will be less likely to take a favorable stance
This article cannot address all the issues that can arise with the land gains tax. However, it should give you the tools necessary for advance preparation that will bear measurable returns in cash, and immeasurable returns in stress relief.