How to Plan for Taxable Gains and Losses

What’s the difference between capital gains and losses and ordinary gains and losses? The classification will have a major impact on your federal income tax obligations when you sell assets, such as investments, real estate, intangibles and other holdings. The classification of assets is generally straightforward, but the issue can be unclear in some situations. Here’s what you need to know if you plan to sell assets.

2 Categories of Gains and Losses

For federal income tax purposes, gains and losses can be classified as either:

1. Capital. These gains and losses result from selling capital assets, which are generally defined as property other than:

• Inventory, meaning property held primarily for sale to customers in the ordinary course of the taxpayer’s business,
• Business receivables,
• Business real and depreciable property, including rental real estate, and
• Certain intangible assets, such as copyrights and letters or memoranda held by the taxpayer for whom they were prepared or produced.

Beware of Unfavorable Treatment for Sales of Self-Created Intangible Assets

Under current tax law, certain self-created intangible assets don’t qualify as capital assets. So when they’re sold, they don’t qualify for preferential long-term capital gain tax rates. Instead, gains from selling affected intangible assets are taxed at higher ordinary income rates.

This unfavorable treatment potentially applies to the following types of self-created intangible assets:

• Patents,
• Inventions,
• Models and designs, whether patented or not, and
• Secret formulas and processes.

The term “self-created” means created by the personal efforts of the taxpayer. What if an affected intangible asset is contributed to another taxable entity, such as a limited liability company (LLC), partnership or corporation? In that case, the unfavorable noncapital-asset treatment rule applies if the tax basis of the intangible asset in the hands of the new owner is determined, in whole or in part, by reference to the basis of the person who created it.

To illustrate, suppose you contribute an affected intangible asset to an LLC, partnership or corporation tax-free in exchange for an LLC membership interest, partnership interest or stock. If the business subsequently sells the intangible asset, it should be treated as ordinary income or loss, rather than capital gain or loss.

Literary, musical and artistic compositions are also generally excluded from the definition of a capital asset. However, under an exception, taxpayers can elect to treat musical compositions or copyrights in musical works as capital assets.

Sales of certain business assets (such as real estate) can result in net Section 1231 gains that are generally treated the same as long-term capital gains (LTCGs) under the federal income tax rules.

2. Ordinary. Ordinary gains and losses can result from selling certain other types of assets. Sales of certain business assets can result in net Sec. 1231 losses that are generally treated as ordinary losses under the tax rules.

Tax Rate Differential on Gains

The major reason it’s important to distinguish capital gains from ordinary gains is the difference in the applicable tax rates. Under current federal income tax rules, net LTCGs recognized by individual taxpayers are taxed at much lower rates than ordinary gains. Currently, the maximum individual federal rate on net LTCGs is 20%, while the maximum individual rate on ordinary gains is 37%. If the 3.8% net investment income tax (NIIT) applies, the maximum rates are 23.8% and 40.8%, respectively.

Here are the current income levels at which the maximum federal income tax rate kicks in for net LTCGs:

2024 Taxable Income Thresholds for Maximum 20% Rate on Net LTCGs

Filing Status–Taxable Income (including capital gains)

Single-$518,900

Married filing jointly-$583,750

Married filing separately-$291,850

Head of household-$551,350

If your taxable income, including any capital gains, is below the applicable threshold, you won’t pay more than 15% on any net LTCG.

Note: The maximum individual federal income tax rate on nonrecaptured Section 1250 gains is 25% (28.8% if the 3.8% NIIT applies). Sec. 1250 gains are long-term gains attributable to straight-line real estate depreciation deductions.

For comparison, here are the current income levels at which the maximum federal income tax rate kicks in for ordinary gains:

2024 Taxable Income Thresholds for Maximum 37% Rate on Ordinary Gains

Filing Status–Taxable Income (including ordinary gains)

Single-$609,350

Married filing jointly-$731,200

Married filing separately-$365,600

Head of household-$609,350

The federal income tax rate on ordinary gains can easily exceed the 15% rate that most individuals will pay on net LTCGs. Here’s a look at when the 22% rate on ordinary gains kicks in for different types of filers:

2024 Taxable Income Thresholds for 22% Rate on Ordinary Gains

Filing Status–Taxable Income (including ordinary gains)

Single-$47,150

Married filing jointly-$94,300

Married filing separately-$47,150

Head of household-$63,100

At higher income levels, the rates on ordinary gains are 24%, 32% and 35%, before hitting the maximum 37% rate. At higher income levels, ordinary gains also can be hit with the 3.8% NIIT.

Net short-term capital gains recognized by individual taxpayers are taxed at the ordinary income rates. They also may be subject to the 3.8% NIIT at higher income levels. Whenever possible, you should hold appreciated capital assets for more than one year to qualify for the much-lower LTCG tax rates.

Deductibility of Losses

It’s also important to distinguish between capital losses and ordinary losses. In general, ordinary losses are currently deductible for federal income tax purposes (unless another set of rules, such as the passive loss rules or the at-risk rules, prevents that favorable outcome).

In contrast, an individual taxpayer’s deductions for net capital losses are limited to only $3,000 ($1,500 for married individuals who file separately). Any excess net capital loss above the currently deductible amount is carried forward to the following tax year and is subject to the same limitation.

How to Classify Business Real Estate

Preferential tax rates apply to only net LTCGs and net Sec. 1231 gains from dispositions of eligible assets. Property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s business is specifically excluded from this favorable treatment. Such assets are classified as inventory under the tax rules.

In determining whether real property is inventory, the U.S. Tax Court has identified the following five relevant factors:

1. The nature of the property’s acquisition,
2. The frequency and continuity of the taxpayer’s property sales,
3. The nature and the extent of the taxpayer’s business,
4. The taxpayer’s sales activities related to the property, and
5. The extent and substantiality of the transaction in question.

Other factors that courts might consider when determining whether real property is inventory include:

• The nature and purpose of the property’s acquisition,
• The duration of the ownership,
• The extent and nature of the taxpayer’s efforts to sell the property,
• The frequency and substantiality of the sales,
• The extent of subdividing, developing and advertising to increase sales,
• The use of a business office for the property’s sale,
• The character and degree of control the taxpayer has over any representative selling the property, and
• The time and effort the taxpayer habitually has devoted to property sales.

No factor (or combination of factors) is controlling. However, the frequency and substantiality of sales is often critical. That’s because the presence of frequent sales generally contradicts any contention that the property is being held for investment, rather than for sale to customers.

Important: Taxpayers have the burden of proving that they fall on the right side of these factors. Under the law, if they fail to meet that burden of proof, the IRS wins the argument.

What’s Right for Your Situation?

It’s almost always better to be able to characterize a taxable profit as a capital gain, rather than an ordinary gain. On the other hand, it’s almost always better to be able to characterize a taxable loss as an ordinary loss, rather than a capital loss. Before you sell a major asset, consult your tax advisor to determine how to handle your transaction under current tax law.

Copyright 2024

This article appeared in Walz Group’s June 17, 2024 issue of The Bottom Line e-newsletter, produced by TopLine Content Marketing. This content is for informational purposes only.