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George Saenz, the Bankrate.com Tax Talk columnist Taxability of right-of-way proceeds

Dear Tax Talk,
I have a huge lot, from which I can give right of way (ROW) to my neighbor, whose land is landlocked due to my property. He is willing to compensate me for ROW to a maximum of $150,000. I want to use this money to fund my expansion project for my existing dwelling.

To avoid income taxes, can I put this money in escrow with my attorney and pay building contractors directly from that escrow account? That way I can avoid reporting it as income and still be able to fund my expansion project with 100 percent ROW proceeds. It's my cake. I want to eat it all.
-- Mark
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Dear Mark,
When you give another person the right of way over your property, you have granted an easement. There are two types of easements. One is that you grant an easement such as to allow a utility to use part of your property. The other is the outright sale of a portion of your property in which you do not retain any interest in the land.

In the first instance you are considered to have been compensated for use of your land and the amount you receive reduces the cost of your property. For example, if your property cost you $500,000 and your neighbor gives you $150,000 to use the entry way for 50 years, you have granted an easement and do not have any gain to report. Instead, your basis in your land is reduced to $350,000 for purposes of computing any future gain on the sale of the property.

In the second case, you are considered to have sold that portion of the land and you have to compute a cost associated with the portion sold. That is, you are considered to have divided your property and sold that portion. For example, if the ROW represents 10 percent of your property, your cost should be $50,000 (one-tenth of $500,000) and you would have $100,000 in taxable gain.

In either case the use of the proceeds will not affect your taxation. Therefore, putting the money with the attorney to use for an expansion project does not change the outcome of its taxation.

To ask a question on Tax Talk, go to the "Ask the Experts" page, and select "taxes" as the topic.

Bankrate.com's corrections policy-- Posted: March 29, 2007
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