Capital gains and income

Capital gain vs. ordinary gain rates

Ordinary income includes wages, salaries, and interest earned and is typically taxed at the taxpayer’s tax rate on taxable income. Capital gains are realized on the sale of a security, real estate, or other asset held for investment. This gain can be short-term (held for one year or less) or long-term (held for more than one year). The taxation on capital gains is generally lower, especially for long-term gains, encouraging longer-term investments. See Schedule D instructions for various capital gain worksheets.

Definitions

Capital gain

Profit realized from the sale of a capital asset such as stocks, real estate, or other investments. Short-term capital gains (assets held one year or less) are taxed at ordinary income rates. Long-term capital gains (assets held more than one year) are generally taxed at lower preferential rates.

Ordinary income

Income from wages, salaries, self-employment, interest, and other non-capital sources, taxed at the taxpayer’s regular marginal tax rate.

Installment sales

Taxpayers have an option when property is sold.

• Either recognize the gain in the year of sale or
• Receive a portion of the the gain in payments over a period of time

Example: Sale of land

Here is a step-by-step example of calculating the profit percentage for an installment sale of land:

Scenario:
Selling Price: $100,000
Adjusted Basis (cost plus selling expenses): $40,000
Terms: $20,000 down payment in the year of sale, and the remaining $80,000 paid in four equal annual installments of $20,000 each (plus interest).

Calculation Steps:
Calculate the Gross Profit: This is the total gain you expect to make on the sale.
Gross Profit = Selling Price - Adjusted Basis
Gross Profit = $100,000 - $40,000 = $60,000

Determine the Contract Price: The contract price is generally the total selling price minus any liabilities (like a mortgage) the buyer assumes, up to your basis in the property. In this simple example with no mortgage, the contract price is the same as the selling price.
Contract Price = $100,000

Calculate the Gross Profit Percentage: This percentage determines the portion of each payment that is considered profit.
Gross Profit Percentage = (Gross Profit / Contract Price) * 100
Gross Profit Percentage = ($60,000 / $100,000) * 100 = 60%

Reporting the Gain
Using the 60% gross profit percentage, you report 60% of each principal payment received as taxable gain for that year. The remaining 40% is a tax-free return of your basis. The interest is reported on Schedule B, Form 1040.

Year of Sale (Down Payment): $20,000 payment received.
Taxable Gain = $20,000 * 60% = $12,000

Subsequent Years (Each Annual Payment): Each $20,000 annual payment is received.
Taxable Gain = $20,000 * 60% = $12,000 for each year

Definitions

Adjusted basis

The original cost of a property plus capital improvements and minus any depreciation taken. It is used to calculate the gain or loss on the sale of an asset.

Gross profit percentage

The ratio of total expected gain to the contract price of an installment sale, expressed as a percentage. It determines what portion of each installment payment received is recognized as taxable gain for that year.

Contract price

In an installment sale, the total amount the buyer agrees to pay the seller, generally equal to the selling price minus any liabilities assumed by the buyer that do not exceed the seller’s basis in the property.

Sidenote

Make sure you know…

Mortgage or other loan debt debt assumed by the buyer and accumulated depreciation, if rental or other income-producing property, will lower cost basis.

Refer to form IRS Form 6252 for application of installment sale calculations.

Supplemental income

Rental income

Rental income is derived from use of tangible property and is reported on Schedule E, Form 1040. Types of rental income include:

• Advance rent payments
• Payments for cancelling a lease
• Expenses paid by a tenant
• Property or service in lieu of rent
• Repairs or maintenance for the property owner

A security deposit is not included in rental income until it is used by the landlord or owner in the event that the tenant has violated any of the terms of the lease or agreement.

NOTE: Rental activity that includes services i.e., meals, laundry, transportation, etc., are subject to SE taxes and reported on Schedule C.

Rental activities are considered passive and have passive loss limits. Passive activity with active participation to qualify for real estate professional status, individuals must work in real estate related activities for at least 750 hours for more than half of the tax year. Also, they should have earned more than 75% of their income from real estate activities during any 3 years within the past 5 years. The taxpayer must demonstrate that he/she must be able to substantiate that the business is operating to make a profit and they have spent more time running the real estate business than other activities, including wage earners. This would qualify the “real estate professional” to report rental activities on Schedule C.

Taxpayers who do not qualify to be a real estate professional are passive activity taxpayers with active participation. Taxpayers in this category are usually those who are full-time wage earners and operate and manage their rental activity in their spare time.

• Deduct up to $25,000 passive losses against ordinary income if your modified gross income(MAGI). The deduction begins to phase out at $100,000 and is completely phased out at $150,000.
• Passive losses can be carried forward indefinitely but must be used as they are generated, as illustrated on Form 8582.
• As well as rental activities, passive activities also include leasing equipment and limited partnerships.

Definitions

Passive activity

A trade or business in which the taxpayer does not materially participate. Rental activities are generally treated as passive under IRS rules, meaning losses can typically only be deducted against other passive income.

Passive activity loss (PAL)

A loss from a passive activity that exceeds passive income. PALs cannot be deducted against ordinary (non-passive) income in the current year; they are suspended and carried forward to offset future passive income or recognized when the entire activity is disposed of.

Real estate professional status

A tax classification that allows a taxpayer to treat rental activities as non-passive if they meet specific IRS requirements: working at least 750 hours in real property trades or businesses in which they materially participate, and spending more than half of their total working hours in real estate activities.

Rental of vacation home

The Internal Revenue Service (IRS) has specific guidelines to determine whether your property is considered a personal residence, a rental property, or a mixed-use property, and these classifications impact how you report income and deduct expenses.

If a vacation home is rented out for 14 days or less during the entire tax year, the rental income is not taxable, but any rental expenses are non deductible.

• Personal expenses such as mortgage interest and property taxes are deductible, subject to the usual limitations.
• Property that is rented for 15 days or more during the year, you must report all rental income you receive. You can deduct ordinary and necessary expenses related to the rental activity. However, the deductibility of these expenses depends on whether the property is considered a residence or a non-residence for tax purposes.

Royalty income

A royalty is a payment made to an asset owner (licensor) for the right to use their property, The payments are typically a percentage of revenue or a fixed fee per unit sold, allowing the owner to earn money as others profit from their creation, and are defined in legal licensing agreements that detail terms, duration, and calculation methods.

Royalty Income is derived from use from your work or investment in the following:

• Oil, gas, and mineral properties as well as
• Use of intangible properties i.e., patents, trademarks, copyrights.
• Works by artists, writers, and musicians
• Books
• Film/Media
• Distributive share of profit or loss from partnerships and S-corporations

Royalty Income and Loss Recognition

In all scenarios, ordinary and necessary expenses incurred to produce the royalty income are deductible. These can include operating costs, maintenance, and for mineral properties, depletion allowances.

• Business Income (Schedule C): If a taxpayer is in the business of being a self-employed writer, artist, inventor, or holds an operating mineral interest, the royalty income and expenses are reported on a IRS Schedule C, Profit or Loss From Business (Sole Proprietorship). In this case, a net loss can typically be used to offset other types of ordinary income, subject to general business loss limitations, such as the excess business loss rules.
• Supplemental Income (Schedule E): If the royalties are not derived from a trade or business (e.g., inherited mineral rights or investment property), they are generally reported as supplemental income or loss on IRS Schedule E, Supplemental Income and Loss. Losses from these activities may be subject to passive activity loss (PAL) rules, which can limit the ability to deduct losses against non-passive income. Unallowed passive losses can generally be carried forward to future years or deducted when the entire activity or property is sold.
• Sale of Property (Schedule D): Gains or losses from the sale or exchange of the underlying intellectual property (e.g., patents, copyrights) or mineral property itself are generally treated as capital gains or losses and reported on IRS Schedule D, Capital Gains and Losses.

Recognizing a tax loss is a standard accounting practice when expenses exceed revenue. The classification of the royalty activity determines which specific IRS form is used and what loss limitations apply.

Definitions

Royalty

A payment made to the owner of an asset (the licensor) for the right to use that asset. Royalties are typically calculated as a percentage of revenue or a fixed fee per unit and are governed by licensing agreements.

Depletion allowance

A tax deduction for the gradual exhaustion of natural resources (such as oil, gas, or minerals) extracted from the ground. Similar to depreciation for physical assets, it allows the owner to recover the cost of the resource over time.

Schedule K-1 information

Schedule K-1 is a tax reporting document for a shareholder or partner’s distributive shares of net income, losses, and separately stated deductible and nondeductible expenses from a partnership or corporation, respectively. Shareholders and partners in pass-through entities, such as S-corporations and partnerships, must maintain accurate records of their investment basis. This is critical for tax compliance, as distributions from the company—detailed on the annual Schedule K-1—can become taxable capital gains if they exceed the owner’s adjusted basis. Schedule K-1 is also used to report the same from estates and trusts to beneficiaries. Schedule K-1s should be issued to taxpayers no later than March 15th or the third month after the end of the entity’s tax year or fiscal year. Click on links below to view the forms: Form 1065 (Schedule K-1) and Form 1120-S (Schedule K-1).

Definitions

Schedule K-1

A tax reporting document issued to shareholders, partners, or beneficiaries showing their proportionate share of income, deductions, credits, and other tax items from a pass-through entity such as a partnership, S-corporation, estate, or trust. Recipients use this form to report their share on their individual tax return.

Distributive share

A partner’s or shareholder’s allocated portion of a pass-through entity’s income, gain, loss, deduction, or credit, as specified in the partnership agreement or S-corporation bylaws. The distributive share is reported on Schedule K-1 and flows through to the individual’s tax return.