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Introduction

Any gain made upon the sale of real property may be taxed as capital or as ordinary income depending on whether that property is classed as a “capital asset” under § 1221 of the Internal Revenue Code (IRC).1 This primer discusses how to determine whether real property may be considered a capital asset for federal tax purposes.

The difference between capital gains and ordinary income can be significant for sellers as capital gains are usually taxed at a lower rate than ordinary income. For example, in 2019, an individual paid a maximum federal income tax rate of 37% on ordinary income, but only 20% on long-term capital gain.2 For corporations, capital losses can be used to offset capital gains and decrease overall tax liability,3 however, qualifying for capital gain treatment is a complex and multi-faceted legal question.

Capital gains are derived from the sale of capital assets and real property is generally categorized as a capital asset, unless specifically excluded by § 1221. This primer focuses on subsection 1221(a) (1), which excludes property held by the taxpayer primarily for sale to customers in the ordinary course of that taxpayer’s trade or business. The courts apply a three-part test to determine whether the property qualifies for the § 1221(a)(1) exclusion by analyzing seven key factors, which are explored below.

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[1] 26 U.S.C.

[2] Internal Revenue Services, Topic No. 409 Capital Gains and Losses, (May 2019), online: https://www.irs.gov/taxtopics/tc409.

[3] Id.

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