Selling a rental home or a part of your real estate portfolio can be a stressful time, but did you know it can greatly affect the amount of tax you pay if the profits aren’t classified correctly?
The IRS can examine your tax return to determine if the real estate is investment income (taxed as capital gains) or business income (taxed as ordinary income).
In general terms, capital gains tax is applied when you use a property for investment purposes, and ordinary income tax is applied when your real estate activities are determined to be ordinary income. The second option will often lead to higher tax rates and self-employment tax, so it helps to work out which one applies to you.
Case Study: Flood v Commissioner (T.C. Memo. 2012-243)
For context, in the case of Flood, T.C. Memo. 2012-243, the court reviewed whether profits from Donald Flood’s sale of a group of vacant lots should be taxed as capital gains or ordinary income. Flood was active in both stock trading and real estate, and argued that the land sales were for investment purposes and should fall into the capital gains tax bracket.
However, after applying nine different criteria to the sales, the IRS reclassified the profits as taxable under ordinary business income, which meant they were subject to higher tax rates and self-employment tax. The Tax Court then upheld the IRS’s suggestion.
The Nine Factors Used To Classify Property Sales
In reaching its decision, the Tax Court considered the following nine factors, as suggested by the IRS.
- Purpose of acquiring the property
- Purpose for which the property was held
- Taxpayer’s everyday business and how the sales are related to total income
- Frequency and volume of sales
- Extent of improvements made to the property
- Efforts to advertise or promote sales
- Use of a business office
- Control over representatives selling the property
- Time and effort devoted to selling the property
Mr Flood had bought 250 vacant lots and fully marketed them using advertising, a real estate agent, and even developed a dedicated website. These actions alone helped the court to determine that he was actively involved in the real estate business, as opposed to holding property for investment. This is why his profits from the aforementioned sales were treated as ordinary income rather than capital gains.
The Complexity of Capital Gains vs Ordinary Income
The Flood case on its own shows how complex it can be to determine whether your real estate sales will be classified as being taxed under Capital Gains or Ordinary Income tax rules, and no single factor guarantees a specific outcome, with the IRS looking at the entire picture of your real estate activities.
If you’re entering into any real estate sales situation, you must evaluate each part carefully before you begin so that unexpected tax issues don’t arise. Our advice? Consult with McSwain Hiott or any other tax professionals to help guide and explain your unique situation. We can help you avoid any costly mistakes by assessing whether or not your individual classification of real estate sales will affect your tax bill.
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