Living off the land

Dear Tax Talk,
My husband and I bought 42 acres of residential property in 1992. We built a home on it and, upon completion of the home, we had the five acres that included the home surveyed out of the original tract and then mortgaged that section and the home. Now we would like to sell approximately five acres of the original tract and use the money from the sale to pay off our existing mortgage. Will we have to pay capital gains? If so, how can we figure out what we will owe? -- Judith

Dear Judith,
Almost everyone knows by now that when you sell your home, you can qualify to exclude up to $500,000 in gain. However, in your case, you're not selling the home, but rather the adjoining property. Since it doesn't involve the sale of your home, you won't qualify for the home sale exclusion. Instead, the sale of the property would be taxed as a long-term capital gain. The difference between what you receive for the sale and your cost for the five acres sold would be taxed at the long-term capital gains rate of 15 percent.

In order to come up with the cost of the five acres you're selling, you need to allocate your cost from the original purchase. A simple allocation would be to take the original cost of the 42 acres and divide it equally. For example, if the original cost of the property was $42,000, then each acre has a cost of $1,000 and the five acres to be sold would have a cost of $5,000.

If the five acres you anticipate selling are more valuable than the remaining acreage, then you should develop an allocation that increases the cost of that parcel. For example, you might want to have an appraisal of the entire property. Then allocate your original cost based on the value of the land you're selling to the entire appraised value. For example, if the appraisal comes in at $100,000 and you sell the five acres for $20,000, then 20 percent of your original cost would be allocated to the portion sold. The Internal Revenue Service will respect whichever method you use, as long as it's reasonable.