Capital gains or ordinary income?

11 Replies

Say if I entered into escrow on a property, went through entitlements, and put in money to develop the project, and upon successful achievement of entitlements sold the property for a higher price than what I was in contract for, would the profits fall into the category of capital gains or ordinary income (like in a wholesaling transaction).

Will reach out to an accountant in a couple weeks but curious to what people generally do in this circumstance.

Thanks in advance. 

@John Kim

The things my CPA usually start to get confusing when I ask a question like this but I think the answer has to do with what your day job is. If you primarily make your money as a real estate developer or real estate agent, then I think it can be considered income. Otherwise, I think it is capital gains.

I think the real answer to this is somewhat complicated and has to do with legal interpretations of tax law but this was the part that I distilled down. Hopefully a CPA on BP here can fill in any important pieces I'm overlooking.

It might also depend on how long you have owned it.  For stocks as an example, if you own it less than a year it’s ordinary income rather than capital gains.

Length of ownership doesn't come into play here. 

Intent does. 

If you're seeking out a property to improve and re-sell for profit, that's ordinary income tax subject to SE tax as well. 

Flipping is only capital gains if it's kind of a one off ....if was meant to be a rental and then you got a unsolicited offer, or you inherit a property and fix it up, ect .

Per this article, it speaks to the level of involvement one has with the property, if it is purely investment and no actions taken to improve its value, classified as capital gains.  

https://www.thetaxadviser.com/issues/2012/dec/clinic-story-06.html

In determining whether the income should be classified as ordinary income or capital gain, the court evaluated nine criteria: (1) the taxpayer's purpose in acquiring the property; (2) the purpose for which the property was subsequently held; (3) the taxpayer's everyday business and the relationship of the income from the property to the taxpayer's total income; (4) the frequency, continuity, and substantiality of sales of property; (5) the extent of developing and improving the property to increase sales revenue; (6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales; (7) the use of a business office for the sale of property; (8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property; and (9) the time and effort the taxpayer habitually devoted to sales of property. It is important to note that, under Sec. 1221(a)(1), property is not a capital asset if it is "stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer . . . or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business."

Originally posted by @John Kim :

Per this article, it speaks to the level of involvement one has with the property, if it is purely investment and no actions taken to improve its value, classified as capital gains.  

https://www.thetaxadviser.com/issues/2012/dec/clinic-story-06.html

In determining whether the income should be classified as ordinary income or capital gain, the court evaluated nine criteria: (1) the taxpayer’s purpose in acquiring the property; (2) the purpose for which the property was subsequently held; (3) the taxpayer’s everyday business and the relationship of the income from the property to the taxpayer’s total income; (4) the frequency, continuity, and substantiality of sales of property; (5) the extent of developing and improving the property to increase sales revenue; (6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales; (7) the use of a business office for the sale of property; (8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property; and (9) the time and effort the taxpayer habitually devoted to sales of property. It is important to note that, under Sec. 1221(a)(1), property is not a capital asset if it is “stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer . . . or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

You would have to be a passive investor in a deal to qualify as having no involvement at all. 

IRS has ruled people acting on your behalf still qualifies as your involvement- so if you buy the property and hire a contractor to run the renovation for you- that's still active participation on your part. 

Originally posted by @John Kim :

Per this article, it speaks to the level of involvement one has with the property, if it is purely investment and no actions taken to improve its value, classified as capital gains.  https://www.thetaxadviser.com/issues/2012/dec/clinic-story-06.html

The fascinating part about this article is that its author works for "Gray, Gray and Gray LLP" CPA firm. How fitting!

Originally posted by @John Kim :

Per this article, it speaks to the level of involvement one has with the property, if it is purely investment and no actions taken to improve its value, classified as capital gains.  https://www.thetaxadviser.com/issues/2012/dec/clinic-story-06.html

I don't agree with your simplistic conclusion. "No actions taken..." is one of many relevant factors, and courts have been rather inconsistent in assigning importance to each of the possible factors.

What I agree with is your earlier conclusion: "Intent is the biggie but then looks like there are some possible wrinkles and could get complicated."

Whenever there's a question of ordinary v capital gains, rarely the situation is 100% one way or the other. We often advise our clients to balance their tax advantages against the level of risk they're willing to accept. As long as your position has reasonable justification (which is very often the case) - you're not breaking the law. However, the IRS can challenge your position, and your disagreement may or may not be resolved without going to court. So the question becomes - are you willing to concede if the IRS disagrees? How far are you willing to take the fight? Is it worth it? The answers are case by case.

Originally posted by @Michael Plaks :
Originally posted by @John Kim:

Per this article, it speaks to the level of involvement one has with the property, if it is purely investment and no actions taken to improve its value, classified as capital gains.  https://www.thetaxadviser.com/issues/2012/dec/clinic-story-06.html

The fascinating part about this article is that its author works for "Gray, Gray and Gray LLP" CPA firm. How fitting!

 Ha!  Didn't notice that!

Met with an accountant and he said that if I close on the property then sell the project to the LLC that I form with my LP, it could be classified as short term cap gains. And like others have mentioned my stance was really dependent on my risk tolerance.

I also asked what might happen on exit after the project is stabilized and not unexpectedly he said that the lines were a bit gray. He said since I have a full time job, the hold period is going to be 3 yrs, and that the project is already built and will have a light value-add component he thought it wasn't unreasonable to classify it as capital gains although it wasn't a bulletproof argument. He mentioned the decision really depended on my risk tolerance.