When it comes to managing your finances, understanding the differences between capital gains and losses and ordinary gains and losses is crucial. These classifications significantly impact your federal income tax obligations when you sell assets such as investments, real estate, intangibles, and other holdings. While the classification of assets is typically straightforward, it can become complex in certain situations. This guide provides the essential information you need to navigate asset sales effectively.
Categories of Gains and Losses
For federal income tax purposes, gains and losses are categorized into two types: capital and ordinary.
- Capital Gains and Losses
Capital gains and losses arise from selling capital assets. Generally, capital assets include all property except:- Inventory (property held primarily for sale to customers in the ordinary course of business),
- Business receivables,
- Business real and depreciable property, including rental real estate,
- Certain intangible assets, such as copyrights and letters or memoranda held by the taxpayer for whom they were prepared or produced.
- Additionally, literary, musical, and artistic compositions are usually excluded from the definition of capital assets. However, taxpayers can elect to treat musical compositions or copyrights in musical works as capital assets.
Sales of specific business assets, such as real estate, can result in net Section 1231 gains, which are typically treated the same as long-term capital gains (LTCGs) under federal income tax rules. - Ordinary Gains and Losses
Ordinary gains and losses result from selling other types of assets. Sales of certain business assets can lead to net Sec. 1231 losses, generally treated as ordinary losses under tax rules.
Tax Rate Differential on Gains
The distinction between capital gains and ordinary gains is vital due to the difference in applicable tax rates. Under current federal income tax rules, net LTCGs recognized by individual taxpayers are taxed at significantly lower rates than ordinary gains. Presently, the maximum individual federal rate on net LTCGs is 20%, compared to 37% for ordinary gains. If the 3.8% net investment income tax (NIIT) applies, the maximum rates rise to 23.8% and 40.8%, respectively.
Here are the current income thresholds for the maximum federal income tax rate on net LTCGs:
- Single: $518,900
- Married filing jointly: $583,750
- Married filing separately: $291,850
- Head of household: $551,350
If your taxable income, including capital gains, is below these thresholds, you won’t pay more than 15% on any net LTCG.
For comparison, here are the current income levels for the maximum federal income tax rate on ordinary gains:
- Single: $609,350
- Married filing jointly: $731,200
- Married filing separately: $365,600
- Head of household: $609,350
The federal income tax rate on ordinary gains can easily exceed the 15% rate most individuals pay on net LTCGs. The 22% rate on ordinary gains kicks in at these income levels:
- Single: $47,150
- Married filing jointly: $94,300
- Married filing separately: $47,150
- Head of household: $63,100
At higher income levels, ordinary gains are taxed at 24%, 32%, 35%, and finally the maximum 37% rate, with the possibility of the 3.8% NIIT applying.
Net short-term capital gains recognized by individual taxpayers are taxed at ordinary income rates and may be subject to the 3.8% NIIT at higher income levels. Whenever possible, holding appreciated capital assets for more than one year is advantageous to qualify for the lower LTCG tax rates.
Deductibility of Losses
Distinguishing between capital losses and ordinary losses is also essential. Generally, ordinary losses are currently deductible for federal income tax purposes, unless other rules, such as passive loss rules or at-risk rules, prevent this favorable outcome.
In contrast, individual taxpayers’ deductions for net capital losses are limited to $3,000 ($1,500 for married individuals filing separately). Any excess net capital loss above the deductible amount is carried forward to the following tax year and is subject to the same limitation.
How to Classify Business Real Estate
Preferential tax rates apply only to net LTCGs and net Sec. 1231 gains from eligible asset dispositions. Property held primarily for sale to customers in the ordinary course of business is excluded from this favorable treatment and classified as inventory.
When determining whether real property is inventory, the U.S. Tax Court considers several factors:
- The nature of the property’s acquisition,
- The frequency and continuity of property sales,
- The nature and extent of the taxpayer’s business,
- The taxpayer’s sales activities related to the property,
- The extent and substantiality of the transaction.
Other considerations include the duration of ownership, the taxpayer’s efforts to sell the property, the frequency and substantiality of sales, the extent of subdividing, developing, and advertising to increase sales, the use of a business office for property sales, the taxpayer’s control over representatives selling the property, and the time and effort devoted to property sales.
No single factor is controlling; however, the frequency and substantiality of sales are often critical. Frequent sales generally contradict the claim that the property is held for investment rather than for sale to customers.
Taxpayers bear the burden of proving their classification falls on the favorable side of these factors. If they fail to meet this burden of proof, the IRS wins the argument.
What’s Right for Your Situation?
It’s almost always preferable to characterize a taxable profit as a capital gain rather than an ordinary gain. Conversely, it’s usually better to characterize a taxable loss as an ordinary loss rather than a capital loss. Before selling a major asset, consulting a tax advisor to determine how to handle your transaction under current tax law is crucial.
Seek Expert Guidance from a Tax Consultant
Navigating the complexities of taxable gains and losses can be challenging. To ensure you’re making the best decisions for your financial situation, seek the expertise of a professional tax consultant. At Burton McCumber & Longoria, our experienced team is here to help you maximize your tax benefits and minimize liabilities. Contact us today to schedule a consultation and get personalized advice tailored to your needs.
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