Ordinary Income Property Vs. Capital Gain Property
Any asset can be considered ordinary income property or capital gain property, depending upon the circumstances. It is the federal tax code and the characterization of the property by its owner, which determines whether an exchange or transfer of the property results in ordinary income or a capital gain. The tax treatment of a gain from the sale of any given property depends upon length of time and the purpose for which the property is held.
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Ordinary income defined
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Ordinary income is any income that is not considered a capital gain. According to the Internal Revenue Service (IRS), the term "ordinary income" includes any gain from "the sale or exchange of property which is neither a capital asset nor property" described in section 1231(b). Typically ordinary income involves weekly or monthly wages, bonuses, tips or commissions. But when it involves the sale of property, only property held for a short-term is categorized as ordinary income property. A good example of this type of property would be business inventory.
Capital Gain Defined
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The term "capital gain" is defined by 26 U.S.C.§1231. The actual language of that statute is complex and is the subject of a myriad of federal regulations. A short hand definition of the term is that a capital gain is any gain realized from the sale or exchange of a capital asset that is: 1) used in trade or business, or 2) is held for more than one year and is held in connection with a trade or business or a transaction entered into for profit. A good rule of thumb is that any property held more than one year will be treated as capital gains property.
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Why It Matters
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The sale of any type of real or personal property will usually result in what IRS regulations define as a 'taxable event'. How the income realized from that transaction is taxed depends upon how the IRS categorizes that income. Ordinary income is usually taxed at a lower rate than capital gains to encourage investment in capital assets.
Knowing Basis
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Before you can determine whether you have a gain, you must know your cost or basis for the property being sold. If you purchased the property, the basis will be your cost in acquiring it. Capital gain is determined by subtracting the basis or cost from the proceeds obtained through a sale. Basis rules can be tricky, depending on how the property was acquired. If you inherited the property there are special rules that apply and you should check the regulations.
Like kind exchanges
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Taxpayers can avoid capital gains taxes on a sale or exchange of property by meeting the requirements of 26 U.S.C.§1031. Under that statute a taxpayer may reinvest the proceeds of the sale or exchange of a capital asset within 180 days following the transaction in property that is of like kind and avoid tax on the transaction.
Tips
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Plan ahead. Always consider the tax consequences before entering into a transaction that could result in capital gains.
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References
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