Capital gains on sale of home with farm

Dear Tax Talk,
I purchased five acres of land seven years ago. Four acres have been developed into an avocado grove four years ago. I am building a custom home on the one acre. If I sell the property — avocado grove and house — after one and a half years, what will my tax rate be? Will the grove be separated from the house and taxed at a different rate?

Thank you.

— Virginia

Dear Virginia,
Generally you can exclude gain from the sale of a home and adjacent vacant land if you owned and used the property as your principal residence for more than two years. However, it might be questionable even if you wait out the two years whether the grove qualifies as adjacent land used as part of your principal residence.

Generally the operation of a grove for profit is considered a farming activity. If the avocados produce a profit, then the land is considered farmland and when sold would not qualify as gain exclusion from the sale of your home. However, if the avocado farming is just a hobby (i.e., not for profit) then the land may be considered part of your home and could qualify for gain exclusion as vacant land.

To claim the gain exclusion on the sale of your main home, you have to wait for two years after you build and occupy the home as your primary residence. If you only wait for one and a half years, the sale of the home and the grove would be considered long-term capital gains. Assuming there is no change in the tax law, after 2007 some of your capital gains income can be taxed as low as zero percent, depending on your overall income, and at a maximum of 15 percent. There is no difference in the rate between the grove and the home.

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