Is Selling Property At a Loss an Ordinary Loss or Capital Loss? | USTaxAid

Diane Kennedy's Blog

Is Selling Property At a Loss an Ordinary Loss or Capital Loss?

Written by Diane Kennedy, CPA on October 30, 2021

I received a very timely question at USTaxAid.com. The community member had purchased a bare piece of property for investment years ago. It was never rented or used for business. Then, this past year, the property was sold at a loss.

The question was pretty easy. Would the loss be considered an ordinary loss or a capital loss?

The question was easy, but the answer was not. He’d heard both answers and came to USTaxAid.com to find the right answer. And maybe to find out why nobody could seem to agree. 

Ordinary Loss vs Capital Loss

Let’s start with the easy question. Who cares? An ordinary loss can be used to offset all types of income, capital gains, earned income, passive income, portfolio income, you name it. A capital loss can only be used to offset capital gains, plus $3,000 per year. Excess capital loss is carried forward, basically forever. It can only be used to offset capital gains in future years plus $3,000 each year.

In other words, an ordinary loss is much better tax designation than a capital loss.

When is a Property Loss Ordinary or Capital? 

This is where it gets tricky. A property loss could be an ordinary loss, or it could be a capital loss.

The difference is determined by whether the property had been put “into service.” Is it part of the taxpayer’s business?

For example, if the property had been rented, then it definitely was part of the taxpayer’s business and was in service. Because of the unique nature of real estate, if the property was sold at a gain, it would be a capital gain but if it was sold as a loss, it would be an ordinary loss. It’s the best of both worlds!

If the taxpayer was a land developer who regularly subdivided lots or bought, held and then sold land, it would be part of the business. That means a loss would be an ordinary loss.

But if the property had been treated just as a one-off type of investment, then the loss would be a capital loss.

That’s probably why the taxpayer was getting different answers. From just a few lines that were submitted as part of US Tax Aid Tax Questions, I was sure that the taxpayer would get a lot of different answers. 

Tax answers are sometimes objective and sometimes subjective. It’s always better to get objective answers. If you follow these 3 steps, you can be a Real Estate Professional. If you buy a business meal from a restaurant, you get a 100% deduction in 2021.

Those are examples of objective answers. If you do this then you get that as a result.

Subjective is less clear. It doesn’t have much to do with facts and figures and is more like “it feels like….” 

Unfortunately, this part of tax law is subjective. What does it feel like? An investment or a business?

One Sale Counted as Ordinary Loss

Frederic Allen bought land in 1987 and for almost 10 years he tried to develop it. He spent some money on engineering plans and he took out a second mortgage on the property.

He never actually put any of the plans into play and after paying for a few engineering plans, the property just sat.

Finally, he sold it at a gain. He reported it as a long-term capital gain because it was an investment. If it had been a rental property, it could also have been considered for long-term capital gain treatment. But if it was built for resale, in other words, just like inventory, then the sale would be an ordinary gain.

The IRS said that the land was not a capital asset. It had been “held primarily for sale to customers in the ordinary course of business.” That meant the gain was ordinary gain and taxed at a much higher rate.

The case went to Tax Court and they agreed with the IRS.

It should be an ordinary gain.

Case by the USTaxAid Community Member

So in the case that was sent to me. It hadn’t been placed in service. But had it been held as a long-term investment (capital loss) or was it held for sale to other parties (ordinary loss)? For example, had there been any discussion to subdivide the property?

When it comes to subjective tax situations like this, make sure your facts line up as well as possible with the tax position you want and are clearly stated. Obviously, you can’t make up tax ‘facts”, but you can make sure you have documented your tax position clearly. 

2 Comments

  1. Rick Azar cpa says:

    Held as investment, rented and depreciated, then sold for gain. Recaptured depreciation is ordinary income and excess gain is LTCG….right? Or?

  2. Diane Kennedy says:

    Hi Rick:

    The gain minus recaptured depreciation is taxed at capital gain rate. If it’s over the year, it’s long term. (LTCG)

    Long way around to say “yes”

    🙂

Leave a Comment

SIGN UP TO DIANE’S FREE NEWSLETTER!

  • Three weekly emails with free tax updates
  • Exclusive deals on products and services
  • FREE Video: How to Write Off Practically Anything