Typically, classifying gains and losses from selling an asset is fairly straightforward. However, there are some gray areas that may require a closer look at the facts and circumstances. This is especially important when real estate is involved in a few recent cases demonstrate.

Why Classifying Capital and Ordinary Losses Matters
Distinguishing between capital and ordinary gains and losses is imperative for two reasons.

1. Tax rates on gains. Net long-term capital gains recognized by individual taxpayers are taxed at lower rates than ordinary gains. (“Long-term” means the asset has been held for more than one year.) Under the current rules, the maximum individual federal rate on net long-term capital gains is 23.8%, if the 3.8% net investment income tax applies (20% + 3.8%). In contrast, the maximum individual rate on ordinary gains, including net short-term gains, is 43.4%, if the 3.8% net investment income tax applies (39.6% + 3.8%).

The maximum individual federal rate on long-term capital gains attributable to real estate depreciation deductions (so-called “nonrecaptured Section 1250 gains”) is 28.8% (25% + 3.8%).
2. Deductibility of losses. Ordinary losses are currently deductible unless tax law provisions, such as the passive loss rules, don’t prevent this favorable treatment. In contrast, deductions for net capital losses are strictly limited.

Annual net capital loss deductions for individual taxpayers are limited to only $3,000 (or $1,500 for married individuals who file separately). Any excess net capital loss (above the currently deductible amount) is carried forward to the following tax year and is subject to the same limitation.

Net capital losses incurred by C corporations can’t be currently deducted. Instead, they only can be carried back for three years or carried forward for five years. (Note: these periods are different from those for net operating losses.)

Five-Factor Test for Classifying Real Property
Sales of capital assets qualify for treatment as capital gains or losses. Capital assets specifically exclude inventory. Inventory is property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s business.

The U.S. Tax Court and the Ninth U.S. Circuit Court of Appeals have identified the following five factors as relevant when determining whether real property is inventory:

  1. The nature of the acquisition of the property
  2. The frequency and continuity of property sales by the taxpayer
  3. The nature and extent of the taxpayer’s business
  4. Sales activities of the taxpayer with respect to the property
  5. The extent and substantiality of the transaction in question

Taxpayers have the burden of proving that real property isn’t inventory. If they fail to meet that burden of proof, the IRS will win the argument.

The Evans Case 

In a recent decision, the Tax Court addressed the issue of whether a taxpayer’s redevelopment property was a capital asset or inventory held for sale to customers. (Jeffrey Evans v. Commissioner, T.C. Memo 2016-7)

The taxpayer was a full-time employee of a real estate development firm. Outside of his regular job, he purchased residential real estate properties in Newport Beach, Calif. He intended to demolish the existing structures on the property and build a two-unit residential structure that he would either sell or rent out. The taxpayer incurred costs to prepare the property for redevelopment, including:

  • Architectural, electrical, and mechanical plans and permits
  • Property taxes
  • Interest expense

The taxpayer borrowed $250,000, and the lender obtained a lien on the Newport Beach property. The taxpayer defaulted on the loan, and the lender foreclosed. The property was eventually sold at a loss in a foreclosure sale. The taxpayer’s position was that the foreclosure loss was an ordinary loss. The IRS claimed it was a capital loss.

Based on its evaluation of the five factors (above), the Tax Court concluded that the taxpayer’s personal real estate activities didn’t constitute a business. According to the Tax Court, the Newport Beach property was held for investment rather than held for sale to customers in the ordinary course of business. Therefore, the property was a capital asset and the taxpayer’s loss was a capital loss

When to Call an Advisor About Losses
It’s always better to be able to characterize a taxable gain as capital rather than ordinary. Conversely, characterizing taxable losses as ordinary rather than capital is generally beneficial. A Barnes Wendling tax advisor can help you understand this issue, and when debatable facts and circumstances arise, he or she will be able to build a defensible case for favorable treatment of gains and losses.