ON THE MONEY
Hamill: Character counts 鈥� especially on your tax return
Booker T. Washington, a man born into slavery, said: 鈥淐haracter is Power.鈥� Many others have spoken of the importance of character.
For Booker, character had a certain meaning. For tax advisers, it has an entirely different meaning.
Tax advisers speak of the 鈥渃haracter of income.鈥� An odd use of the term. But in tax law, character means ordinary, capital, or section 1231.
Even with this odd use of the term, in tax law, character is also power. Power to reduce your tax liability.
Ordinary income is taxed at your highest marginal tax rate 鈥� a rate that can reach 37% for high-income individuals.
Both long-term capital gains and section 1231 gains can be taxed at much lower rates.
Single individuals pay a zero capital gains rate for taxable income up to $49,450. Married filing jointly (MFJ) filers pay zero up to $98,900 of taxable income.
Single filers pay 15% on gains if taxable income is above $49,450 but not above $545,000.
MFJ filers pay 15% on gains if taxable income is above $98,900 but not more than $613,700.
For those with taxable income above the higher threshold, long-term capital and section 1231 gains are taxed at 20%.
If you generate income, that income should have the character of long-term capital or section 1231, and not ordinary income.
Losses are a bit different. Ordinary losses will reduce your income without limit. Section 1231 losses also reduce income without limit.
Capital losses are limited to $3,000 per year. Capital losses may reduce capital gains but otherwise carry forward to be used at $3,000 per year.
Section 1231 assets are depreciable property used in a business or any real property used in a business.
Capital assets are investment assets. Ordinary assets are those that do not fall within either of these categories.
Technically, capital assets are defined by exclusion. They are everything but the things the law says they are not.
But it is fairly safe to define a capital asset as one acquired for investment purposes. Long-term means the asset was held for more than one year.
Section 1231 assets must also be held for more than one year. If not, what might have been a section 1231 asset becomes an ordinary asset.
It can sometimes be challenging to distinguish a capital from a section 1231 asset. This is particularly so with smaller real estate properties.
For example, the IRS thinks a single rental house is a capital asset. Tax advisers often argue it is a section 1231 asset.
The distinction arises because a section 1231 asset must be used in a business. Can a single rental house be considered a business?
The debate usually arises when the property is sold at a loss. The IRS wants to limit the loss to $3,000 (capital); taxpayers want no limit (section 1231).
The debate also arises in the net investment income tax paid by higher-income individuals. This 3.8% tax does not apply to certain business income.
The 20% deduction for qualified business income also applies only if the rental property is a business.
Section 1231 gains may change their character to ordinary if the taxpayer has reported net section 1231 losses in the last five years.
Both capital and section 1231 gains are subject to 鈥渄epreciation recapture鈥� rules. These rules may convert tax-favored gains to ordinary income.
When an asset is depreciated, the tax basis is lowered by the depreciation. This causes the taxable gain to be higher when the asset is sold.
The theory behind recapture is that the depreciation deduction offsets ordinary income, so the offsetting gain must be 鈥渞ecaptured鈥� as ordinary income.
This creates a symmetry between the character of the deduction and the income.
The real estate industry carved out a special exception to this symmetry.
If the property subject to depreciation is real estate, there is no ordinary income recapture.
Instead, for those who would otherwise be subject to an ordinary tax rate above 25%, the maximum tax on the depreciation-induced gain is 25%.
This potential 25% gain is actually called 鈥渦nrecaptured鈥� gain. The gain remains as capital or section 1231, because there is no recapture as ordinary.
Jim Hamill is the director of tax practice at Reynolds, Hix & Co. in sa国际传媒官网网页入口. He can be reached at jimhamill@rhcocpa.com.
