Capital or ordinary: A realtor's dilemma

One of the frequent concerns of a taxpayer who disposes or transfers his property is the resulting tax consequences. Proper classification of the property to be disposed of or transferred is imperative in order to determine the correct applicable tax. A question which must be first addressed is whether it is a capital asset or ordinary asset.

Section 39 of the Tax Code defines the term “capital assets” by the process of exclusion. The term “capital assets” means property held by the taxpayer (whether or not connected with his trade or business), but does not include the following: 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; property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business; property used in the trade or business, of a character which is subject to the allowance for depreciation ; and real property used in trade or business of the taxpayer.

From the foregoing, capital assets are generally properties that are not used in trade or business of the taxpayer. On the other hand, ordinary assets are properties used in trade or business or primarily held for sale by the taxpayer.

The sale of capital assets (land and/ or building) is subject to capital gains tax at the rate of six percent based on the gross selling price or fair market value at the time of sale, whichever is higher and the corresponding documentary stamp tax (DST). Conversely, sale of ordinary assets is subject to the creditable withholding tax at a rate ranging from 1.5 percent- 6 percent and consequently to ordinary income tax, corresponding DST and likewise to the 12 percent VAT.

Nevertheless, one vital point which must also be considered is the conversion of the classification of the properties. Take for instance, if a taxpayer suffering from financial distress decides to cease its business operations leaving its properties formerly used in business as idle and abandoned. If those properties were subsequently disposed of, what would then be the classification? Would they maintain their classification as ordinary assets? Or will they be converted into capital assets?

Section 3(4) (e) of Revenue Regulations (RR) No. 07-2003 provides for the guidelines in determining whether a particular real property is a capital asset or an ordinary asset. It provides that real properties formerly forming part of the stock in trade of a taxpayer engaged in the real estate business, or formerly being used in the trade or business of a taxpayer engaged or not engaged in the real estate business, which were later on abandoned and became idle, shall nonetheless continue to be treated as ordinary assets. Real property initially acquired by a taxpayer engaged in real estate business shall not result in its conversion into a capital asset even if the same is subsequently abandoned or becomes idle. However, properties classified as ordinary assets for being used in business by a taxpayer engaged in the business other than real estate business are automatically converted into capital assets upon showing of proof that the same have not been used in business for more than two (2) years prior to the consummation of the taxable transactions involving said properties.

As can be seen, the length of the period or the passage of time when real properties have not been used in business and the kind of business a taxpayer/seller is engaged in are the determining factors for conversion to apply. For taxpayers/sellers engaged in the real estate business (i.e. real estate dealer, developer, lessor etc.), idle and abandoned real properties shall continue to be classified as ordinary assets regardless of the length of time they became idle and abandoned. Whereas, for taxpayers/sellers who are not engaged in real estate business (i.e. manufacturing, merchandising etc.), real properties used in business which became idle and abandoned for more than two years will be automatically converted into capital assets.

To what extent does the Bureau of Internal Revenue (BIR) enforce the determining factor of a seller’s line of business, in determining the classification of its real property?

Recently, in BIR Ruling No. 142-2011 dated 04 May 2011, BIR held that the disposition of several vacant lots which remained idle and abandoned for more than two years is considered as a sale of ordinary assets. The seller in this case, is a construction company which has for its secondary purpose that of purchasing, acquiring, owning, leasing, selling and conveying real properties. The BIR held that there was no conversion of the classification of the real property because the BIR considered the seller as a taxpayer engaged in the real estate business.

There may be confusion as to the treatment by the realtor on whether his real property which has become idle and abandoned is a capital or an ordinary asset. However, this “confusion” is more apparent than real. As RR No. 07-2003 is clear and as confirmed by the recent ruling, real property acquired by a taxpayer who is engaged in the real estate business shall not be converted into a capital asset, even if the said real property remained idle and abandoned for more than two years.