Ordinary income tax vs Capital gains

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Ordinary income tax vs Capital gains

Leah Thompson
Member since 2023 · 1 post · 1 vote

Just getting started… and so much to learn. We bought our first property at a foreclosure auction with plans to turn into a rental. Single-family home with large yard, as we learn, now rethinking our strategy.

If we sell now, are we considered dealers and taxed on ordinary income plus a self-employment tax ? How do we get it considered an investment and be taxed capital gains? We formed an LLC and purchased the property through it. The only good part about our learning process and doing it slowly on the side is that we have held it for over a year. We've also thought about a 1031 exchange though concerned we wouldn't be able to find another property soon enough.

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Ashish AcharyaBusiness Member
CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
3y

No, it will not be ordinary if you can prove the initial intension was rental. 

If you were already in the business of flipping, then it would look risky, but you are not. 

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  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    3y

    No, it will not be ordinary if you can prove the initial intension was rental. 

    If you were already in the business of flipping, then it would look risky, but you are not. 

    [email protected]941-914-7779
    INVESTOR FRIENDLY CPA®5241 Reviews
    WebsiteView Page
    TaxMD™ | AI-Powered Tax Planning
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  • Account Closed
    Accountant · New York NY, USA · Member since 2023 · 209 posts · 26 votes
    3y

    When it comes to real estate investments, whether you are considered a dealer or an investor for tax purposes can depend on various factors. The distinction is essential because it affects how your profits are taxed. Here are some key points to consider:

    1. Dealer vs. Investor Status: The IRS distinguishes between real estate dealers and investors. Dealers are typically engaged in the business of buying and selling properties for profit, and their profits are considered ordinary income, subject to both income tax and self-employment tax. Investors, on the other hand, are generally individuals who buy properties for long-term investment and can benefit from capital gains tax rates.
    2. Holding Period: One of the factors that can help establish your status as an investor is the length of time you hold the property. Holding a property for over a year, as you mentioned, can be a positive factor when trying to establish investor status.
    3. LLC Ownership: The fact that you purchased the property through an LLC is also a positive indicator of an investment intent, especially if the LLC is set up as a pass-through entity for tax purposes (like a single-member LLC or a multi-member LLC filing as a partnership). It can help separate your personal finances from your real estate activities and show a business-like approach.
    4. 1031 Exchange: If you decide to sell the property and want to defer capital gains taxes, a 1031 exchange is an option. This allows you to exchange your current property for another investment property without recognizing capital gains. However, you must adhere to strict rules and timelines for identifying and acquiring the replacement property.

    To establish your intent as an investor rather than a dealer, it's important to maintain detailed records of your activities and intentions. This includes keeping records of your plans, holding periods, property improvements, and documentation of your LLC structure. Consult with a tax professional or CPA who specializes in real estate to assess your specific situation and help you make informed decisions about selling, 1031 exchanges, and tax implications. They can provide guidance tailored to your needs and goals

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    3y

    @Leah Thompson, You should be able to talk your accountant into long term capital gains treatment on that property.  But if you do a 1031 you'll mitigate all of your tax anyway.  The fear of not finding a good replacement is common and legitimate.  But you have 45 more days after the closing of your sale to identify your potential replacement properties.  So, if you can get a 60 day close on your sale.  And if you start shopping now for your replacement property,  You can potentially have 4-5 months to locate your replacement Since you can go into contract for your new property before your old property sells.  You just have to close the sale of your old property before you take title to your new property.

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  • Michael PlaksPro Member
    Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
    3y

    @Leah Thompson

    I agree with @Ashish Acharya: you should be able to treat your gains as long-term capital gains. 

    You should also be eligible for a 1031 exchange. However, before exploring it, have a competent accountant calculate the potential tax impact of your sale. It may not be as drastic as you fear, in which case you won't need a 1031.

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