Amount realized. The amount realized on a sale or exchange of property is equal to the sum of the amount of money received, the fair market value of property received, and the debts of the taxpayer that the other party to the exchange pays, assumes, or to which the property is subject. The amount realized on a sale or exchange of real property also includes real estate taxes imposed on the seller if the buyer is to pay such real estate taxes. Essentially, the buyer's agreeing to pay the seller's real estate taxes is a particular type of debt relief.

Election to capitalize interest and real estate taxes. When a taxpayer holds land for investment and the taxpayer's itemized deductions are less than the standard deduction or the alternative minimum tax (AMT) results in no deduction, the taxpayer should elect to capitalize the applicable interest and real estate taxes paid during the year. By capitalizing the interest and real estate taxes, the taxpayer can reduce a gain or increase a loss on the sale or exchange of the land, instead of receiving no benefit from the deduction. This election is made by attaching a statement to the tax return that the taxpayer elects to capitalize interest and/or real estate taxes under §266. An election to capitalize annual carrying costs and taxes with respect to unimproved and nonproductive real property can be changed from year to year. In contrast, an election with respect to real property being developed or personal property continues to be in effect until the real property development is completed or the personal property is installed or in use. Therefore, an election with respect to these properties may be effective for more than one tax year.

Gain or loss realized and recognized. A gain results if the amount realized is greater than the property's adjusted basis; a loss results if the amount realized is less than the property's adjusted basis. Unless a contrary provision (i.e., like-kind exchange) applies, all gains and losses realized by the taxpayer during the year are recognized.

Individuals may not deduct losses on property held for personal use except a loss from a casualty or theft. Although an individual may believe that he or she bought a personal residence for investment, the Code treats a personal residence as a personal use asset and not as an asset held for investment.

A taxpayer cannot deduct any depreciation for a home used only for personal purposes. However, a taxpayer can deduct depreciation on the portion of a home used for a qualified home office. A taxpayer could also have claimed depreciation deductions on his home if he previously used it for business or rental purposes.

Any gain due to the recapture of depreciation claimed on the home after May 6, '97, is not eligible for the §121(d) exclusion. However, a taxpayer may exclude any gain due to depreciation claimed on the home on or before that date, up to the $250,000 or $500,000 §121(d) limit.

Character of gain or loss recognized. If the property is not a capital asset or a §1231 asset, the gain or loss will be an ordinary gain or an ordinary loss. An ordinary gain is fully taxable, and an ordinary loss is fully deductible, unless a particular provision of the Code limits its deductibility. For an individual, recognizable losses from the sale or exchange of property are deductible in calculating adjusted gross income (AGI).

If a taxpayer holds undeveloped land for investment, the character of the gain or loss is a capital gain or loss. The gain or loss is long-term if the taxpayer held the land for more than one year, and short-term if the taxpayer held it for less than one year.

Capital assets are broadly defined as property held by the taxpayer (whether or not connected with his trade or business), subject to certain exclusions. Among other things, capital assets do not include: "stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business."

Capital assets also do not include inventory or property held primarily for sale to customers in the ordinary course of business. In addition, real property and depreciable property used in a trade or business are not capital assets. The period for which the taxpayer held the asset is immaterial in determining whether it is a capital asset.

If a taxpayer does not hold rental property primarily for sale to customers in the ordinary course of business, the property can be a capital asset, an ordinary asset if considered as used in a trade or business and held for one year or less, or a §1231 asset if considered as used in a trade or business and held for more than one year.

Included in §1231 assets are:

(i)         property subject to depreciation used in a trade or business and held for more than one year, and

(ii)        real property used in a trade or business held for more than one year. Capital assets do not include depreciable property or real estate used in a trade or business.

Rental of real estate as a business.  If the rental of houses, apartments, or commercial buildings is a trade or business, then the sale of such properties held for more than one year gives rise to §1231 gains or losses. If the rental of such properties is not a trade or business, the gains and losses on their sale represent capital gains or losses. In determining whether rental real estate is a capital asset or an asset used in a trade or business, a taxpayer must look at all the facts and circumstances and applicable case law.

Self-employment tax issues. Rental income is excluded from self-employment income for purposes of calculating the self-employment tax, unless the taxpayer received the rental income in the course of business as a real estate dealer. A self-employed individual excludes the gains on the sale of real estate from self-employment income unless the taxpayer realized the gains from property held primarily for sale to customers in the ordinary course of business.

If a self-employed individual held real estate primarily for sale to customers in the ordinary course of business, the individual should include the gains and losses on the sale of such real estate in calculating self-employment income. The nominal self-employment tax rate is 15.3%, but a self-employed individual may subtract 7.65% of the unadjusted self-employment income in determining the base for the self-employment tax. A self-employed individual also may deduct one-half of the self-employment tax liability for the year in calculating AGI. Therefore, the distinction between whether a taxpayer held real estate for sale to customers in the ordinary course of business or for investment can be significant.

Treatment of capital losses and net capital gains. An individual or married couple may deduct no more than $3,000 a year of net capital losses. The taxpayer may carry forward any net capital loss in excess of $3,000 indefinitely, subject to the $3,000 limit in each succeeding year.

A taxpayer calculates the net long-term capital gain or loss and a net short-term capital gain or loss. If the net long-term capital gain exceeds any net short-term capital loss, the result is a net capital gain that receives preferential tax treatment. The portion of any gain on the sale of depreciable real estate attributable to depreciation recapture is subject to a tax rate not to exceed 25%. Any other net capital gain on the sale of real estate is taxed at a maximum rate of 15% through 2012.

Treatment of §1231 gains and losses.