Most of the time, how to classify gains and losses from selling an asset is fairly straightforward. But there are some gray areas that require a closer look at the facts and circumstances, especially when real estate is involved, as a couple of recent cases demonstrate.

Beyond Real Property

The issue of deciding how to classify gains and losses from selling an asset affects more than just real estate. In a 2017 private letter ruling, the IRS allowed a termination payment made pursuant to a patent sale agreement to be treated as a capital gain.

This ruling involved three individual taxpayers who owned a patent through a limited liability company (LLC) that was classified as a partnership for tax purposes. The LLC sold all substantial rights to the patent to a third party in exchange for payments from the third party based on sales of the patented product.

When the third party was acquired, it sought to end its obligations to the LLC by making a termination payment. The LLC accepted the offer. The IRS concluded that the Internal Revenue Code allowed favorable long-term capital gains treatment for the taxpayers’ respective shares of the LLC’s gain from the termination payment. Why It Matters

Distinguishing between capital and ordinary gains and losses is an important issue for two reasons:

1. Tax rates on gains.

Net long-term capital gains recognized by individual taxpayers are taxed at much lower rates than ordinary gains. (“Long-term” means the asset has been held more than one year.) Under the current rules, the maximum individual federal rate on net long-term capital gains is generally 23.8%, if the 3.8% net investment income tax applies (20% + 3.8%). In contrast, the maximum individual rate on ordinary gains, including net short-term gains, is 43.4%, if the 3.8% net investment income tax applies (39.6% + 3.8%).

The maximum individual federal rate on long-term capital gains attributable to real estate depreciation deductions (so-called “nonrecaptured Section 1250 gains”) is 28.8% (25% + 3.8%).

2. Deductibility of losses.

Ordinary losses are currently deductible — assuming other tax law provisions, such as the passive loss rules, don’t prevent that favorable treatment. In contrast, deductions for net capital losses are strictly limited.

Annual net capital loss deductions for individual taxpayers are limited to only $3,000 (or $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.

Net capital losses incurred by C corporations can’t be currently deducted. Instead, they only can be carried back for three years or carried forward for five years. (Note that these periods are different from those for net operating losses.)

Five-Factor Test for Classifying Real Property

Sales of capital assets qualify for treatment as capital gains or losses. Capital assets specifically exclude inventory. Inventory is property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s business.

The U.S. Tax Court and the Ninth U.S. Circuit Court of Appeals have identified the following five factors as relevant when determining whether real property is inventory:

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

Taxpayers have the burden of proving that real property isn’t inventory. If they fail to meet that burden of proof, the IRS will win the argument.

The Evans Case

In a recent decision, the Tax Court addressed the issue of whether a taxpayer’s redevelopment property was a capital asset or inventory held for sale to customers. (Jeffrey Evans v. Commissioner, T.C. Memo 2016-7)

The taxpayer was a full-time employee of a real estate development firm. Outside of his regular job, he personally purchased residential real estate properties in Newport Beach, Calif. He intended to demolish the existing structures on the property and build a two-unit residential structure that he would either sell or rent out. The taxpayer incurred costs to prepare the property for redevelopment, including:

• Architectural, electrical, and mechanical plans and permits,
• Property taxes, and
• Interest expense.

The taxpayer borrowed $250,000, and the lender obtained a lien on the Newport Beach property. The taxpayer defaulted on the loan, and the lender foreclosed. The property was eventually sold at a loss in a foreclosure sale. The taxpayer’s position was that the foreclosure loss was an ordinary loss. The IRS claimed it was a capital loss.

Based on its evaluation of the five factors (above), the Tax Court concluded that the taxpayer’s personal real estate activities didn’t constitute a business. According to the Tax Court, the Newport Beach property was held for investment rather than held for sale to customers in the ordinary course of business. Therefore, the property was a capital asset and the taxpayer’s loss was a capital loss.

The Long Case

In another decision, the Eleventh U.S. Circuit Court of Appeals looked at whether an individual taxpayer’s proceeds from selling the rights to buy land and build a luxury condo project were properly characterized as long-term capital gain rather than ordinary income. (Philip Long v. Commissioner, 114 AFTR 2d 2014-6657, 11th Cir. 2014)

In this case, the taxpayer was a real estate developer who operated his business as a sole proprietorship. In 2006, he received $5.75 million in exchange for selling contract rights to buy a parcel of land in Fort Lauderdale, Fla., and build a luxury condominium tower on the parcel. He had been working on this project for 13 years and had obtained the contract rights in a lawsuit involving the property.

The taxpayer treated the proceeds from the contract rights sale as long-term capital gain on his 2016 income tax return. But the IRS, after auditing the taxpayer’s return, claimed that the proceeds were paid in lieu of future ordinary income payments and, therefore, counted as ordinary income.

The Tax Court agreed with the IRS that the proceeds constituted ordinary income, because the taxpayer intended to sell the land underlying the condo project to customers in the ordinary course of his business. On appeal, the Eleventh Circuit reversed the Tax Court’s decision.

The Eleventh Circuit pointed out that the Tax Court had erred by concluding that the taxpayer had sold the land underlying the condo project for the $5.75 million. In fact, he’d never owned the land. What he actually sold was the right to purchase the land pursuant to the terms of the condo development agreement and the associated right to build the condo tower.

The Eleventh Circuit noted that, in certain circumstances, contract rights can qualify as capital assets. Therefore, the real issue in this case was whether the taxpayer held the contract rights primarily for sale to customers in the ordinary course of his business. The Eleventh Circuit found no such evidence. Instead, the evidence showed that the taxpayer had always intended to develop the condo project himself, until he ultimately decided to sell his contract rights instead.

The Eleventh Circuit also concluded that the taxpayer had owned the contract rights for more than one year, because they resulted from a lawsuit that was filed two years earlier. Because the contract rights constituted a capital asset that the taxpayer had owned for more than a year, he was entitled to treat the proceeds from selling the rights as a long-term capital gain.

Need Help?

It’s almost always better to be able to characterize a taxable gain as capital rather than ordinary. Conversely, characterizing taxable losses as ordinary rather than capital is generally beneficial. Your tax advisor can help you understand this issue and, when debatable facts and circumstances arise, build a defensible case for favorable treatment of gains and losses.

Graduation can be one of the most exciting — and intimidating — times in your life. You’re officially an adult, and with that new-found independence comes financial responsibilities. No pressure, but the decisions you make today about spending and saving can mean the difference between struggling for the rest of your life and building a solid financial future.

The Boomerang Generation

Even if they already have a full-time job, recent graduates are increasingly choosing to live with their parent(s) or grandparent(s) to save money. But financial dependence is rarely the sole reason for “boomeranging” home. Instead:

• Young people are waiting longer to get married compared to previous generations. Without a fiancé or spouse to encourage independent living arrangements, many graduates return home, until they finally tie the knot.
• Many empty nesters miss their children and ask them to return, at least temporarily, to help with companionship, medical care and security, financial obligations, and day-to-day chores. Parents often mutually benefit from living with their adult children.

Could this option work for your family? The negative stigma associated with living in a family member’s spare bedroom or basement is rapidly disappearing. A Pew Research survey reports that roughly 75% of young adults who live with their parents are satisfied with their living situation and upbeat about their future finances. That’s about the same satisfaction level as young adults who live on their own. Parents are reportedly just as happy about their adult kids living with them.

Here’s a list of important questions to consider as you start your journey:

1. Where Should You Live?

Depending on where you want to live and how much you earn, you probably can’t move into your dream home right away. The cost of a studio in a big city could potentially get you a huge place out in the country. Your location of choice is tied to many variables — job, family and personal preferences.

To avoid overspending, be realistic about how much you can afford. As a rule of thumb, roughly one-third of your net monthly take-home pay should be used to finance the place you live. If your starting income is modest, you’ll likely pay a higher percentage for housing.

If you decide to rent, always read the entire lease before signing on the dotted line. Find out such details as how long the lease lasts, whether it includes utilities and if there are any fees for terminating the lease early.

If you’ve already saved up money for a down payment, consider buying a condo or single family home. Interest rates are near historic lows. And the sooner you purchase, the quicker you start building equity and claiming tax benefits that come with owning a home.

If you can find a roommate, you’ll have extra money for other living expenses, such as furniture and bills for phone, cable TV and Internet access. Also, don’t forget renter’s insurance to cover your personal belongings in the event of a theft, fire, flood or other disaster. Alternatively, consider the upsides of living with your parents for a little while longer. (See “The Boomerang Generation” at right.)

2. How Much Should You Save Each Month?

No one wants to live paycheck to paycheck. Doing so can lead to significant stress if you lose your job, become disabled or incur a major expense (like a medical bill or car repair). It’s smart to set aside a predetermined amount from each paycheck that goes directly into savings. This amount should be separate from your retirement savings (see below).

Keeping a separate savings account will help prevent you from thinking that this amount is part of your disposable income. As a rule of thumb, you should try to build a “rainy day fund” that equals three to six months of net monthly take-home pay. When the unexpected strikes, you’ll be glad you saved.

3. Why Should You Begin Saving for Retirement Now?

It may seem premature to think about retirement when you start your first real job. But you can amass a large nest egg by saving small amounts when you’re young, because your contributions have time to compound. Plus, any money you put into tax-deferred accounts lowers your taxes in the year you contribute. (Income taxes will be due when you eventually withdraw funds from these accounts, however.)

If your employer offers a retirement plan, such as a 401(k) plan, sign up as soon as possible. Also, find out if your employer makes “matching contributions.” This means the employer adds in a percentage, say 25% or 50%, for every dollar you contribute. Besides employer-provided plans, there are many other retirement planning tools. For example, Roth and traditional IRAs may be beneficial, depending on your personal situation.

As an added bonus, you may be able to borrow from a 401(k) account or take money from an IRA, without paying an early withdrawal penalty, for several reasons, including the purchase of a first home.

4. Do You Need to Buy (or Finance) a Car?

After putting money toward living expenses, savings and retirement, new graduates need to budget for another essential: transportation. Again, you might not be able to afford your dream car right away. Moreover, a car may not be a necessity, especially if you live and work in a city with reliable public transportation.

If you decide to buy a car, consider saving money with a used car. Another way to save money is to look for a car loan with the lowest possible interest rate by:

• Checking your credit. Consider a co-signer if your credit rating isn’t very good or if you haven’t established any credit rating yet.
• Shopping around for interest rates at your bank, credit union and various car dealerships. Try to get quotes from at least three different sources.

If you finance a vehicle through the dealership (because it’s convenient) and later find a lower rate elsewhere, you can pay off the original loan with the lower rate loan. Just make sure the original loan doesn’t include any prepayment penalties. Some homeowners even use home equity loans to finance their vehicles, because the interest is generally tax deductible.

5. What Types of Insurance Do You Need?

Graduation is a good time to make critical decisions about auto, health and life insurance coverage.

Most new graduates get their health insurance coverage through an employer. If you’re unemployed or your employer doesn’t provide coverage, you may be allowed to stay on your parents’ policy for a few more years (until you turn 26). This is likely to hold true even if the Affordable Care Act (ACA) is repealed, as that provision was retained in the bill to repeal the ACA, which stalled in the House earlier this year.

If you can’t get coverage through a parent’s health insurance provider, you need to consider other ways to comply with the ACA’s individual mandate — or you’ll face the shared responsibility penalty. Nonexempt U.S. citizens and legal residents will generally owe this penalty if they fail to have minimum essential coverage for themselves and their dependents for any particular month. Coverage options for the unemployed include:

• Certain government sponsored programs (such as Medicare, Medicaid, and the Children’s Health Insurance Program),
• Plans obtained on the individual market,
• Certain grandfathered group health plans, and
• Certain other coverage specified by the U.S. Department of Health and Human Services in coordination with the IRS.

There are a number of exceptions to the penalty, such as the one for eligible lower-income individuals and the one for some people whose existing health insurance plans were canceled.

Also consider obtaining life insurance. If you sign up when you’re young and healthy, the rates are generally less expensive. Depending on your needs later in life, as well as health issues that can creep up over time, the cost could rise significantly in the future.

6. How Can Discretionary Spending Help You Build Credit?

Any money that’s left over from your paycheck is available for discretionary items, such as vacations, dining out, pets, clothing and personal pampering. Credit cards can be a convenient way to pay for discretionary items, and, as an added bonus, they often accrue rewards points that can be redeemed in the future.

If you don’t already have a credit card, sign up for one to help build credit. But resist the temptation to spend beyond your means. Always pay off your credit cards in full monthly — or you’ll likely incur high interest rates on any unpaid balances. Interest-free financing offers (for, say, a mattress or an appliance) can be another way to save money and build credit, but you must pay off the balance in full before the deal expires — or you’ll incur high interest charges from the original purchase date.

Need Help?

As soon as you graduate, it’s important to establish relationships with tax, business and legal advisors. During your career, you’ll likely need help from experienced professionals who can assist you as your needs evolve. By initiating these relationships now, you’ll know whom to contact when help is needed.

Have you been contemplating moving to another state with lower taxes? Your move could lower your state tax bill, but you want to make sure to establish that the new state is your place of legal residency (also known as your “domicile”) for state tax purposes. Otherwise, the old state could come after you for taxes after you’ve moved. In the worst-case scenario, your new state could expect to get paid, too. Here’s what you need to do to establish residency in the new state — and why moving your pet could be a deciding factor.

Recognize the Significance of Establishing Domicile

If you make a permanent move to a new state, it’s important to establish legal domicile there if you want to escape taxes in the state you left. The exact definition of legal domicile varies from state to state. In general, however, your domicile is your fixed and permanent home location and the place where you plan to return, even after periods of residing elsewhere.

Because each state has its own rules regarding domicile, you could wind up in the worst-case scenario of having two states claiming you owe state income taxes. That could happen when you establish domicile in the new state but don’t successfully terminate domicile in the old state.

Moreover, if you die without clearly establishing domicile in just one state, both the old and new states may claim that your estate owes income taxes and any state death taxes. So, it’s critical to know the rules that apply in your new and old states — and follow them.

How to Establish Domicile in a New State

Here are some actions that can help you establish domicile in a new state:

• Keep a log that shows how many days you spend in the old and new locations. (You should try to spend more time in the new state, if possible.)
• Change your mailing address.
• Get a driver’s license in the new state and register your car there.
• Register to vote in the new state. (You can probably do this in conjunction with getting a driver’s license.)
• Open and use bank accounts in the new state. Close accounts in the old state.
• File a resident income tax return in the new state, if it’s required. File a nonresident return or no return (whichever is appropriate) in the old state.
• Buy or lease a residence in the new state, and sell your residence in the old state or rent it out at market rates to an unrelated party.
• Change the address on important documents, such as passports, insurance policies, and wills or living trusts.

The more time that elapses after you move to a new state and the more steps you take to establish domicile in that state, the harder it will be for your old state to claim that you’re still a resident for tax purposes.

Don’t Forget the Dog

In the facts underlying a recent decision by the New York Division of Tax Appeals, the taxpayer lived in New York City until he took a job as chief executive officer at Match.com, which was based in Dallas, Texas. Ultimately, the court determined that he was legally domiciled in Texas, because that’s where he kept one of his nearest and dearest possessions — his dog. (In re Gregory Blatt, N.Y. Division of Tax Appeals, No. 826504, Feb. 2, 2017)

The taxpayer’s initial agreement with Match.com called for him to work in New York City. But in 2009, he decided to lease an apartment in Dallas and work from the Dallas office. His employment contract was amended to show that his principal place of employment was Dallas. He kept ownership of an apartment in New York City, although it was listed for sale after he agreed to work out of Dallas. He also kept a boat in New York, which he used while vacationing in the Hamptons.

By the spring of 2011, the taxpayer had terminated his employment with Match.com and moved back to New York City. Later in 2011, he sold his apartment in New York City and moved to the Hamptons.

For 2009 and 2010, the taxpayer claimed to be domiciled in Texas and, therefore, filed New York nonresident/part-year resident income tax returns for those two years. After being audited by the New York Division of Taxation, he was charged for state and city income taxes, interest and penalties totaling $430,065 on the grounds that New York City was his legal domicile for the entire time he was employed by Match.com.

Fortunately, the taxpayer was able to convince the New York Division of Tax Appeals that his domicile for 2009 and 2010 was, indeed, Dallas. The following factors helped persuade the court to accept Dallas as the taxpayer’s domicile:

• He started going to the gym in Dallas, which he had never done in New York,
• He had his prescriptions filled in Dallas, and
• He obtained a Texas driver’s license and was registered to vote there.

As it turned out, the tipping point came when the taxpayer moved his dog to Dallas in November 2009. The significance of this action was documented in an email the taxpayer sent to a friend in which the taxpayer stated that moving the dog was the final step that he hadn’t previously been able to come to grips with. By taking the dog to Dallas, the taxpayer demonstrated that Dallas was officially his new home. The New York Division of Tax Appeals agreed, noting that moving items that are “near and dear” tends to demonstrate a person’s intention to change domicile.

Consult a Tax Pro

Planning to move to a new state with lower taxes? Unless you establish domicile in the new state and terminate residency in the old one, you could come under scrutiny by state tax authorities. Your tax advisor can explain the rules in your old and new states and how to avoid potential pitfalls.