Glen Head, NY

The ability to obtain capital gain treatment as a result of a transaction has two distinct advantages over ordinary income treatment.

First, for individual taxpayers capital gains are taxed at lower rates than ordinary income. This advantage may not last as there is talk in Congress to raise the capital gains tax rate.

Second, for all taxpayers, capital losses may be offset against capital gains. Without that offset, corporate capital losses would not be deductible at all (but may be carried forward for five years). Individuals have an advantage over corporations in this regard in that some minimum amount of capital losses may be deductible without capital gains ($3,000 a year or $1,500 for married taxpayers filing separately) and unused capital losses can be carried forward indefinitely.

Current economic conditions and the severe drop in the stock market has lead to an abundance of capital losses that either have been realized or can be realized by a sale and then utilized to offset any capital gains.

Of course to have a capital gain, the asset sold must be a “capital asset” which, among other restrictions, cannot be inventory or property held primarily for sale to customers in the ordinary course of a trade or business.

Subdivided real estate is generally the type of property that causes the most difficulty in determining whether such property constitutes a capital asset. Courts have considered a number of factors in determining whether such real estate qualifies as a capital asset including the frequency and regularity of sales, duration of time the property was held, the purpose for acquiring and holding the property before sale, the extent of the taxpayer's sales efforts by advertising or otherwise, the time and effort the taxpayer dedicated to the sales and how the sales proceeds were used. If the sales proceeds were reinvested in a similar activity as opposed to merely liquidating a current investment, that factor might lean towards a determination of ordinary income.

There is a provision in the Internal Revenue Code for non-corporate taxpayers that allows the sale of certain types of real estate to be considered eligible for capital gain treatment if certain conditions are met even if that real estate might not be considered a capital asset under the above rules.

Section 1237 concerns “Real Property Subdivided For Sale” and will permit capital gain if no substantial improvements that substantially enhance the value of the property are made, and the lot has been held for at least five years. If no more than five lots are sold then all such gains will be capital gains; if six or more lots have been sold then the gains will be part capital and part ordinary income.

While real estate, like so much of the economy is under pressure, if it is possible for a taxpayer to sell real estate now owned and achieve a capital gain and that taxpayer has, or could recognize capital losses, there could be meaningful tax advantages. If this is not the time for such a sale, either because of the troubled real estate market or because the real estate had not been held for five years, it must be remembered that for individuals capital losses that have been realized can be carried forward indefinitely and perhaps the real estate sale can be postponed until the economy improves or until the required holding period has been achieved. But while capital gains can be offset by capital losses, any remaining gains may be taxed at a higher rate in the future if the law is changed.

For more information, in the Tax Management Portfolios, see Rothman, 561 T.M., Capital Assets, and in Tax Practice Series, see ¶1730, Real Property Subdivided for Sale.