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Capital Gain vs. Ordinary Income

When you do a "fix and flip," will the profit be considered ordinary income or capital gain? The answer can be the difference between the 20% maximum capital gain rate and the 39.6% maximum ordinary income tax rate. (And don't forget the lurking 3.8% net investment income tax.)

The tax policy of having a lower rate for capital gains than for ordinary income is often debated.

As noted in Boomhower v. U.S., "The purpose of the statutory allowance of a lower rate of taxation on the gain derived from the conversion of capital assets is to alleviate the burden which would be incurred by the taxpayer, should that gain be classified as ordinary income over a short tax period when, in fact, it had accrued over a long period of investment, and to remove the deterrent effect of that burden on such conversions."

To qualify as capital gain and get the better tax treatment, the asset being sold must qualify as a capital asset. A capital asset cannot be stock in trade of the taxpayer or other property considered inventory. In addition, a capital asset cannot be property used by the taxpayer in her trade or business of a character which is subject to the allowance for depreciation, or real property used in her trade or business. (So-called 1231 property can get capital gain treatment after depreciation recapture.)

For taxpayers who buy a house, fix it up and sell it one time only, it is an easy answer that the sale should get capital gain treatment. (Don't forget there is a one year holding period for long term capital gain treatment.) On the other hand, the taxation of the income of a person who buys many houses, refurbishes them all and sells them to produce most of his income is, also, an easy answer. That person is in the business, and the sales generate ordinary income. The problem is all the cases in between. The answer depends on seven factors as established by the courts. Here are the first three to get you started. Don't hesitate to contact us with questions.

1) Nature and purpose of land acquisition and the duration of ownership. What was taxpayer's intent when the property was acquired? Create condominiums? Hold for long-term investment? How long has property been held? Usually, inventory is not held for a long period of time. It has been held that one of the factors suggesting capital gain treatment is that the gain is the result of appreciation in value over a period of time. However, in other cases, it has been suggested that a delayed sale is merely a marketing technique, an attempt to get the best price for the property.

2) The extent and nature of the taxpayer's efforts to sell the property. Lack of advertising and lack of use of a broker tend to show investment intent rather than business intent of the seller. Lack of advertising of contiguous properties (such as a block of row homes) may not persuade a court that the sales are not part of a business. For widely separated properties, where a prospective buyer could not see other similar properties for sale at one location, lack of advertising would be more likely to result in a capital gain treatment.

3) The number, extent, continuity, and substantiality of the sales. In the Jersey Land Development Corp case, the court stated that factors such as frequent sales, solicitation and advertising, a sales office and other "typical trappings of a real estate business" are much more important in a residential real estate business and should not be as significant in determining the presence of a commercial or industrial property sales business.

-Patti Spencer

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Spencer Law Firm LLC
320 Race Ave
Lancaster, PA 17603

Toll Free: 866-639-5451
Phone: 717-207-7935
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