Capital vs. Ordinary: Classifying Income and Losses Affects Your Taxes
How to Classify Income & Losses and its Effect on Your Taxes
Classifying your income and losses as capital versus ordinary will undoubtedly affect your taxes. Although the methodology behind declaring gains and losses obtained from selling an asset is seemingly straightforward, recent studies have indicated that, particularly when real estate circumstances are taken into consideration, gray areas do exist.
What is a capital gain, and how can we distinguish it from ordinary income?
The answer seems simple. If you have a job, the money you are paid for your work is ordinary income. If you buy an asset at one time and sell it later for a higher price, the profit you made from holding it is a capital gain.
Why Classification Matters
There are two very pertinent reasons that assist in distinguishing between ordinary and capital gains and losses:
- The Taxable Rate on Gains: the net from long-term capital gains can be recognized by individual taxpayers at far lower rates than ordinary gains. The definition of “long-term” capital gains are those gains or losses which have been held for more than the duration of one year. Current tax regulations all indicate that that the maximum individual federal tax rates on net long-term gains is somewhere in the vicinity of 28.3%. This 28.3% tax figure is the aggregate of the 3.8% net investment income tax on top of the 20% regular rate (20% + 3.8% = 28.3%). Ordinary gains (including those which are short-term, however, are currently taxed at a rate of 43.4%. This is the aggregate of the highest tax bracket rate combined and the 3.8% net investment tax (39.6% +3.8%). As a special note, the absolute maximum federal tax rate on long-term gains from real estate sales is 28.8% (25% + 3.8%). Like we mentioned, the tax process is not very simple and an expert CPA’s advice should be sought when complicated situations like this arise. As a business, your first priority should be compliance with all and any tax laws.
- Losses and if they can be Deducted: One thing is somewhat clear: ordinary losses are deductible. These ordinary losses are deductible assuming other tax provisions don’t prevent a deduction from being processed with, for lack of a better word, “favorable” treatment. In contrast, deductions associated with net capital losses are very closely monitored and limited. For losses incurred by C corporations that would fall into the net capital loss arena, no deductions are allowed. To compensate for this tax structure, net capital losses are able to be carried back to the tax year subject to several limitations.
Real Property & 5 Factors to Assist you in Classification
Gains or losses and their subsequent treatment as capital gains and losses is a difficult subject to comprehend. Another note…specifically excluded from the category of a capital asset is the following: inventory- a class of assets held by taxpayers for sale to clients and a foundation of the normal course of business. Fortunately, both the Ninth U.S. Circuit of Appeals and the U.S. Tax Court have identified five critical factors which are relevant to determining whether real property is considered inventory:
- The substantiality and extent of a transaction
- The true nature of a taxpayer’s operations
- The nature of said property’s acquisition
- The activities concerning sales related to the property in question
- The continuity and frequency of property sales by the property owner
The burden of proof here is on the taxpayer to demonstrate that real property is not inventory. If the taxpayer cannot substantiate proof, the IRS will win the case in question.
A Real-life Case Study: The Evans Case
The Evans Case is a recent case in which the U.S. Tax Court addressed an issue concerning a taxpayer’s redevelopment property. This property was under question because it was unclear whether the redevelopment was a capital asset or inventory being held for sale to clients. This case is officially listed as Jeffrey Evans v. Commissioner, T.C. Memo 2016-7.
This particular taxpayer, Jeffrey Evans, was a real estate development firm’s full-time employee. Evans happened to also be legally investing in residential real estate properties in the Newport
Beach, California locale. Evans’ intention was to demolish existing buildings on properties he owned; one structure that he built was a two-family unit structure which he intended to either rent or eventually sell. Mr. Evans also incurred certain costs related to his redevelopments such as property taxes, electrical expenses, mechanical fees and agricultural permits and plans.
Evans also had borrowed a significant dollar amount of $250,000 from a Newport Beach lender via his obtaining a lien. After this event, Evans quickly defaulted on the loan and his respective lender foreclosed on the property. The lender ended up selling the property at a loss in its foreclosure sale. Evans’ position was that this loss should be considered an ordinary loss; the stance that the IRS took was the opposite..that this was indeed a capital loss.
The U.S. Tax Court, in its findings based on the five criteria mentioned above, ruled that the property owned by Evans did not meet the criteria for qualification as a business. Rather, the Court ruled that the property in Newport Beach was held for investments rather than sales to clients. This conclusion ultimately meant that the property was a capital asset and any loss incurred was deemed a capital and taxpayer loss.
A Second Real-life Case Study: Looking Beyond Real Estate
Just to clarify, the dilemma of how to classify losses or gains from an asset sale does not stop with real estate. In an extremely recent, but very private, a 2017 IRS ruling declared that a termination payment made for a patent sale could be treated as a capital gain.
In this very complicated case, three separate individual taxpayers had owned a patent via a limited liability corporation (LLC). Once this LLC sold any and all substantial patent rights to a third party buyer, the third party agreed to give a portion of the patent’s proceeds, in the form of payments, to the original LLC members.
The original three members of the LLC sought to end all relevant obligations to its LLC by proceeding and making a termination payment. The IRS concluded that its Internal Revenue Code would allow this arrangement to qualify for the more favorable long-term capital gains treatment for the mentioned three taxpayers’ shares garnered by the sale of their LLC.
Need assistance in determining the right avenue that your business or personal investment sale should pursue? Contact Thomas Huckabee, CPA for a free consultation.