When an individual investor sells a real estate investment for profit, he or she is often concerned about whether the profit is capital gain or ordinary income. And for good reason…
Basic Rules of Real Estate Profit Taxation
A capital gain is often taxed at 15% (though sometimes higher if a taxpayer’s income is subject to the Medicare surtax or exceeds $400,000) as long as the investor holds the property for more than year. Ordinary income and short-term capital gains, in comparison, are taxed at rates that go as high as 44%.
Obviously, then, one wants to treat profits as long-term capital gains when possible. A great real estate deal that produces, say, $100,000 of profit triggers $15,000 in taxes if you can call the profit “long-term capital gains,” but triggers as much as $44,000 in federal income taxes if you must call the profit “ordinary income” or “short-term capital-gains.”
All that said, however, most real estate investors know that to get preferential capital gains treatment, one simply must hold the property for more than a year. So this short article doesn’t talk more about that.
The big remaining question, really, is when can long-term real estate profits be treated as long-term capital gains? And that’s often tricky.
So When is Real Estate Profit Capital Gain?
Unfortunately, determining whether a particular real estate investment will be taxed as a capital asset or as an ordinary income asset is tricky. Courts and the Internal Revenue Service rely on a variety of factors to determine when real estate profits should rightly be taxed as capital gain. Three of the most important factors, however, follow:
Factor 1: Sweat Equity
If your labor—your sweat equity—explains your real estate profits, the profit should generally be taxed as ordinary income.
If you bought a piece of raw land and then went through the hassle of getting property subdivided and then the work of putting in a road and utilities, for example, the profit probably ties pretty directly to your efforts. Through your sweat equity, you converted undeveloped raw land into building lots. Because the profit flows pretty directly from your sweat equity, the profit should almost certainly be taxed as ordinary income.
Here’s another example. Assume you flip houses. Say that you buy beat-up repossessed homes in auction, clean them up, and then sell them. You’re making money almost the same way that a homebuilder does. Again, the profit should almost certainly be taxed as ordinary income.
Note that the flip side of this “sweat equity” factor should be true, too. If you have done nothing to a property other than what a real estate investor would always do, your inactivity or passivity probably becomes a pretty good argument for treating your profits as capital gain.
If you haven’t done anything to increase the value of the property, your real estate profits probably reflect long-term or short-term appreciation, which is exactly the sort of investment profit that capital gains rates are supposed to tax.
Factor 2: Lots and Lots of Real Estate Activity
Here’s another factor that can affect whether real estate profits are taxed as capital gain or ordinary income. If you’re actively and regularly selling properties, then your profits are probably taxed as ordinary income because your real estate activities resemble those of a ordinary retailer who buys and sells lots of items.
For example, say you buy and sell ten or twenty houses a year. Or say you developed a hundred acres of raw land into five hundred building lots and are selling several dozen lots a year. In these cases, your high activity levels suggest that you’re running an active trade or business—a business that buys and sells real estate. And profits that stem from an active trade or business are subject to ordinary income tax rates.
But, again, note that the flip side of this coin can also be true. If you sell property only once, or only during a blue moon, that infrequency makes a strong case for treating your profits as capital gains.
Factor 3: Investor Patience
One final big factor should be mentioned. The length of time you hold a particular real estate investment may affect how the profits are taxed. Repeatedly, tax-related court cases have dealt with whether the real estate profits should be taxed as ordinary income or as capital gains.
Again and again, courts have noted that Congress created capital gains tax rates to alleviate the hardship of taxing profits that come from long-term appreciation as ordinary income.
What’s more, the longer the period that you’ve held a property, the more likely it is that the increase in value stems from general appreciation and not from factors such as sweat equity or something akin to the profit that any active trade or business would earn by buying and selling inventory.
Closing Caveats and Comments
Two other comments should be made about the taxation of real estate profits.
First, note that capital asset treatment is a two-edged sword. Consider the situation where a real estate investment doesn’t produce profits but instead produces losses. A loss that’s a capital loss can only erase capital gains and up to $3,000 of other, ordinary income. Ordinary losses, however, erase ordinary income.
A bad real estate deal that produces—let’s just be really pessimistic—a $1,000,000 loss will save you potentially as much as $350,000 in income taxes if you can fairly label the loss as an ordinary loss.
In comparison, if you have to call the loss a capital loss, you might only get to claim a $3,000 a year capital loss deduction, which could only mean a few thousand dollars in tax savings. To fully use up a $1,000,000 capital loss deduction at the rate of $3,000 a year, you would need to file more than 300 annual tax returns!
And here’s a second issue to consider—an issue which many real estate investors miss. If your real estate activities do rise to the level of an active trade or business, you get hit not only with ordinary income tax rates, but you also get hit with self-employment taxes of roughly 15% on the first $100,000 of profit and then roughly 3% on the profits above that. (An S corporation or a well-structured limited liability company can partially solve this self-employment tax problem, but only if the corporate or LLC structure is correctly set up beforehand.)
If you’re interested in learning more about real estate taxation, feel free to contact us.