Q: I was selling a large piece of land to a developer. The developer signed an option to purchase contract and deposited $70,000 annually into an escrow account for five years.
With the real estate market downturn, the developer defaulted on the contract and I will receive $350,000 out of escrow. Is this money ordinary income or capital gain income for IRS purposes?
A: Unfortunately for you, this cash would be considered ordinary income. You did not sell a capital asset but rather received a payment under the contract.
When you own investment property (including stocks, investment real estate, and other long term holdings) and have held it for a year or more, any profits from the sale of that property would be taxed at a lower tax rate than what most people earn as salary or other income.
Currently for higher income amounts the tax rate for capital gains is 15 percent and the highest rate for ordinary income is 35 percent. In addition to any federal tax owed, you may owe state tax on this income.
In your case, your income is derived from the termination of the contract rather than the sale of the land. You should talk to your accountant further as to whether your contract was structured in a way that would permit you to consider the cash payments as anything other than ordinary income. But for most contract cancelations, that money should be considered ordinary income.
May 28, 2008.