Buying land from the grandparents

Dear Tax Talk,
I am in the process of purchasing 2.6 acres from my grandparents' farm in Ohio for $26,000. They currently reside on the farm and have owned it for over 50 years, and I will be purchasing land from their field and hope to build a house. We first considered setting up a land contract where they would transfer the deed to the land and I would make monthly payments directly to them.

I started making calls concerning getting a construction loan to build a house, and so far I have heard that I will have a hard time getting a loan to build a house on land that I do not own. They suggest that I roll the land costs into the mortgage and pay off my grandparents, but the whole reason we set up monthly payments was to avoid capital gains taxes (which thoroughly confuse me). One mortgage broker I spoke to said that they should not incur any capital gains taxes unless the sale was for over $300,000 or they owned it for less than two years; however, I have not found any confirmation of this. Do you have any suggestions?

Also, is there much difference in capital gains if they receive $3,000 per year for 10 years, or $26,000 lump sum? -- Jared

Dear Jared,
There's no reason to be so confused. Your grandparents are dividing their land and selling you a portion of it. If you pay them for that land, they have a capital gain. Since they've owned the land forever, the maximum tax rate is 15 percent; it can be less.

One of the main considerations in receiving a lump sum versus receiving money over a period of years has to do with the effect on the taxability of any Social Security benefits they're receiving. If they recognize the full amount of income in one year, it may cause their Social Security income to be taxed, so that they may end up owing more than the 15 percent on the land sale. But it shouldn't be much more than 15 percent.

If your grandparents don't have other income, they might end up paying some tax if they receive all the money at once vs. over a period of 10 years. I ran an example assuming that the folks have $20,000 in Social Security benefits and $5,000 in other income; they might end up paying $1,400 in tax by receiving the $26,000 in one year. Since they're not selling you their home, the mortgage broker was incorrect on the exclusion.

If you want to avoid the tax altogether, your grandparents could gift you the land. In that event, since they would be so kind as to give you the land, you could help them out with a small gift each year as well.