7794 / What deductions are available to the owner of vacant land? How is gain or loss on sale treated?

Apparently, investment in vacant land is treated as a passive activity if the activity is (1) a rental activity (as defined below and in Q 8011 and Q 8016), or (2) a trade or business in which the investor does not materially participate.⁴ The rental of property used in a trade or business is treated as incidental to a trade or business activity (rather than a rental activity) during any year if (1) the taxpayer owns an interest in the trade or business activity during the year, (2) the property was predominantly used in the trade or business activity either during the year or in two out of the five preceding years, and (3) the gross rental from the property for the year is less than 2 percent of the lesser of (a) the unadjusted basis of the property, or (b) the fair market value of the property.⁵

It also appears that investment in vacant land is treated as an investment activity (rather than a passive activity) during any year in which the principal purpose for holding the property during such year is to realize gain from the appreciation of the property. The rental of investment property is treated as incidental to an investment activity (rather than a rental activity) if the gross rental from the property for the year is less than 2 percent of the lesser of (1) the unadjusted basis of the property, or (2) the fair market value of the property.⁶

Example 1. Mrs. Martin holds 1,000 acres of unimproved land with a fair market value of $350,000 and an unadjusted basis of $210,000. She holds the land for the principal purpose of realizing gain from appreciation. In order to defray the cost of carrying the land, she rents the land to a rancher who uses the land to graze cattle and who pays rent of $4,000 per year. The rental of the land is treated as incidental to an investment activity rather than a rental activity. This is determined as follows: (1) The lesser of the unadjusted basis ($210,000) or the fair market value ($350,000) is $210,000. (2) Two percent of $210,000 equals $4,200. (3) Gross rental of $4,000 is less than $4,200.⁷

Example 2. In 2025, Mrs. Vickers acquired vacant land for the purpose of constructing a shopping mall. Before commencing construction, she leased the land under a one-year lease to a car dealer, who used the land to park cars held in his inventory. In 2026, Mrs. Vickers begins construction of a shopping mall on the land. Since the land was acquired principally for the purpose of development rather than held for appreciation, the rental of the land in 2025 cannot be treated as incidental to an investment activity. Also, the rental of the land cannot be treated as incidental to a trade or business activity because the land has never been used in a trade or business. The rental of the land is thus treated as a rental activity subject to the passive loss rules.⁸

In general, a taxpayer’s aggregate losses from passive activities may offset only his or her aggregate income from passive activities.⁹ See Q 8010 to Q 8021.Interest allocable to property held for investment purposes is generally deductible only up to the aggregate amount of the taxpayer’s “investment” income.¹⁰ See Q 8040.

Gain or loss on sale will be treated as capital gain or loss unless the property is (1) used in the taxpayer’s trade or business, in which case it will be “IRC Section 1231” property subject to rules discussed in Q 7834, or (2) held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business in which case it will be ordinary gain.¹¹ A special rule applies to gain of a person who is not a dealer but develops land and sells parcels. See Q 7795.If the investment in vacant land is treated as a passive activity, gain or loss from sale of the property is generally gain or loss from a passive activity. See above.