“…but in this world nothing can be said to be certain, except death and taxes.” – Ben Franklin
The Internal Revenue Code (IRC) classifies real estate assets, for federal income tax purposes, based on the owner’s intended use of the property at the time of acquisition. There are currently 4 categories of classification, each with their own unique treatment (and benefits) under federal tax laws:
Property held as a personal residence
Personal residences are not eligible for cost recovery deductions or 1031 exchanges.
Property held for sale to consumers (dealer property)
Dealer properties are not eligible for cost recovery deductions, tax deferred (1031) exchanges, or installment sale tax treatment. Gains and losses on sales are considered ordinary business income. Dealer properties can be office, industrial, retail, or land with the common theme being that they real estate is being built or subdivided (land) for the purpose of being sold.
Property held for use in trade or business (Section 1231)
The real estate asset must be held for more than one year and is eligible for cost recovery deductions. Gains and losses resulting from the sale of such properties are treated separately from those on investments in other property types. The benefit of this particular class is that gains (above the property’s basis) are taxed at the lower capital gains rate while losses can offset the taxpayer’s ordinary income. Section 1231 properties can be exchanged (1031) for other qualifying Section 1231 or Section 1221 assets.
*Extremely important to note is that one’s trade or business could be “real estate investor.” This means that such properties could be an office building owned and occupied by a company or a retail center being purchased with the intent of a long-term hold as a rental property.
Property held as an investment (capital assets, Section 1221)
Otherwise known as capital assets, these properties are not eligible for cost recovery deductions but can be exchanged (1031) for other qualifying Section 1221 or Section 1231 assets. An example of such an asset would be vacant land held for appreciation.