How are sales of real estate such as land and buildings reported on your tax return? Is the net income (or loss) taxed as ordinary income or capital gain? The answer is that it “depends.” The determination is based on the facts and circumstances of the situation and the intention of the taxpayer. There is no bright-line test.

Which is preferable – ordinary income or capital gain? You might automatically assume the answer is capital gain, especially if the real estate has been held for more than one year prior to the sale and qualifies for lower long-term capital gains rates. Yes, ordinary income tax rates are higher than long-term capital gain rates, but there are various nuances that must be considered when reporting the sale of real estate as ordinary income versus capital gain.

Sale taxed as ordinary income

Pros

  • Allowed to deduct ordinary and necessary business expenses to reduce net income
  • Eligible for the 20% qualified business income deduction
  • If a loss, can deduct entire loss

Cons

  • Subject to self-employment tax
  • Taxed at higher rate

Sale taxed as capital gain

Pros

  • Taxed at lower rate (if long-term)
  • Not subject to self-employment tax

Cons

  • Can only deduct costs that increase basis in property, or property taxes
  • If a loss, the current year deduction may be limited
  • Not eligible for the 20% qualified business income deduction

The root of the determination is whether or not you are in the business of buying and selling real estate. If the answer is yes, the sale is classified as ordinary income. If the answer is no, the sale is classified as capital gain. How is this determination made? Who gets to decide? You? Your CPA? While you and your CPA will likely discuss the details of your situation and come to a decision as to how to report the sale on your tax return, the ultimate decision rests with the IRS.

The following nine criteria from a 2012 tax court case can be used as a guide for factors that the IRS may consider when determining if income is classified as ordinary or capital gain. It is unclear how many of the tests must be passed for the sale to be considered as qualifying for capital gain treatment.

  1. The taxpayer’s purpose in acquiring the property
  2. The purpose for which the property was subsequently held
  3. The taxpayer’s everyday business and the relationship of the income from the property to the taxpayer’s total income
  4. The frequency, continuity, and substantiality of sales of property
  5. The extent of developing and improving the property to increase sales revenue
  6. The extent to which the taxpayer used advertising, promotion, or other activities to increase sales
  7. The use of a business office for the sale of property
  8. The character and degree of supervision or control the taxpayer exercised over any representative selling the property
  9. The time and effort the taxpayer habitually devoted to sales of property 

It is important to note that property held as inventory for sale to customers is not considered a capital asset, and as such, does not qualify for capital gain treatment. The sale of unimproved real estate has caused many disputes between taxpayers and the IRS. The IRS has attempted to limit this area of controversy by providing that a single tract of land with no substantial improvements that is owned for more than five years will not, under certain circumstances, be considered held primarily for sale to customers. Therefore, it will be capital gain property—even if it had been subdivided. However, if a taxpayer subdivides the land or engages in activities incident to the subdivision or sale, it is likely to be inventory and subject to ordinary rates if sold within five years.

If you are considering selling real property, such as land or a building, consult your KTLLP advisor to discuss the tax implications relevant to your specific situation.