Careful Treatment of Property Sales Can Yield Tax Savings

The question of whether the sale of property will yield capital gains or ordinary income is an important tax consideration. Currently, the maximum individual rate on ordinary income is 43.4 percent, yet it is only 23.8 percent on long-term capital gains. With a potential tax rate difference this large, determining the proper treatment of property sales is vital. The problem in making a determination is that it depends on a variety of factors. There are no clear or easy answers.

The tax code assumes all assets are capital assets unless they qualify for ordinary treatment by exclusion. Generally, real property is not considered a capital asset if a taxpayer holds it primarily for sale in the ordinary course of business. The seven Winthrop factors are used to help figure out if a sale was conducted in the ordinary course of business. These seven factors are explored below.

Factor 1 - Duration of Ownership and the Nature and Purpose of the Acquisition

The original intent in acquiring the property is important. The purpose of your acquisition is usually deemed to hold at the time of the sale unless there is substantial evidence of a change. Proving a change of purposes is not easy, especially when the change is from a trade or business activity to an investment one. Holding the property for a substantial length of time does lend support to capital gain treatment; however, it does not guarantee it.

Factor 2 - Nature and Extent of the Efforts to Sell the Property

The more promotion activities the taxpayer engages in such as advertising and soliciting customers, the more likely that the sale will generate ordinary income.

Factor 3 – Frequency and Number of Sales

The more frequent and numerous the property sales you engage in, the more likely you are to be deemed a dealer and therefore subject to ordinary tax rates. It is important to remember that this is one of, if not the most significant factor.

Factor 4 - The Extent of Development and Advertising

If you develop real property by grading, rezoning, installing roads or other improvements, you may be deemed a dealer. This means the sale will result in ordinary income.

Factor 5 - Maintaining an Office for the Sale of the Property

If you keep an office to conduct the sale of your properties, especially with the proper licenses and permits, you are more likely to be considered to be acting in the trade or business and therefore taxed at ordinary rates.

Factor 6 - Degree of Control Exercised Over the Representative Selling the Property 

If you sell the property yourself or exert significant control over the agent selling on your behalf, the transaction is more likely to be considered to have been performed in the ordinary course of your trade and will thus result in ordinary income.

Factor 7 - Time and Effort Devoted to the Sale

If you spend a significant amount of your time and effort in selling real estate, then that property has characteristics of inventory. If revenue from real estate sales is also the taxpayer’s main source of revenue, then the property is likely to be characterized as an ordinary income-producing asset.

Conclusion

You should exercise caution when determining what type of gain a property sale generates. The factors discussed above should be carefully considered and judged in their totality. Lastly, even with a thoughtful and judiciously determined position, there is no guarantee that your position won’t be examined.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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