In the field of taxation, understanding the classification of assets is crucial. This article delves into the special rules that govern the classification of real property or land as either an ordinary asset or a capital asset.
The distinction between these two types of assets is not merely academic. It carries significant financial implications, particularly in terms of taxation. If real property or land is classified as a capital asset, the tax imposed by the Philippine government on its sale is a six percent (6%) capital gains tax. On the other hand, if deemed an ordinary asset, the sale will be subject to a twelve percent (12%) value-added tax (VAT) applies.
Given the substantial difference in tax rates, it is essential for property owners, investors, and professionals in the field to accurately classify their assets and understand the rules that guide this process. This article aims to shed light on these special rules, providing a comprehensive guide to navigate the complex landscape of asset classification in real estate. Stay tuned as we delve into the intricacies of these classifications and their implications.
Real Property or Land is Classified as Either an Ordinary Asset or Capital Asset
For purposes of taxing a sale or other disposition of real property or land, the Bureau of Internal Revenue must first determine whether such property is considered as an Ordinary Asset or a Capital Asset. This determination is important because it fixes, among others, the type of tax to be paid for the sale or property, i.e., whether to pay twelve prevent (12%) Value Added Tax if the sale involves an ordinary asset, or six percent (6%) capital gains tax if the sale involves a capital asset.
When Real Property or Land is considered an Ordinary Asset
‘Ordinary assets are properties which are specifically excluded from the definition of capital assets under Section 39(A)(1) of the National Internal Revenue Code (NIRC), as amended. Thus, only the following properties are classified as ordinary assets:
a. 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
b. Real property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business; or
c. Real property used in the trade or business (i.e., buildings and/or improvements) of a character which is subject to the allowance for depreciation provided in Subsection (F) of Section 34; or
d. Real property used in trade or business of the taxpayer.[1]
Please be aware that a taxpayer, even if not initially involved in the real estate business, will be deemed as such if they regularly sell property or engage in related activities. Any property acquired by such a taxpayer will be classified as an ordinary asset. Indeed, the completion of at least six taxable real estate transactions in the previous year, irrespective of the total amount, serves as evidence of the taxpayer’s involvement in the real estate business.
Furthermore, a property acquired for prospective business use retains its status as an ordinary asset, even if unforeseen circumstances prevent its intended use. Similarly, the cessation of active use of the property does not alter its previously determined classification as a business asset.
When Real Property or Land is considered a Capital Asset
On the other hand, capital assets shall refer to all real properties held by a taxpayer, whether or not connected with his trade or business, and which are not included among the real properties considered as ordinary assets under Sec. 39(A)(1) of the NIRC.[2]
It is crystal clear that real properties may only be considered as “ordinary assets” if such are held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business or is used in his trade or business. Otherwise, such property shall be classified as “capital assets.”
Revenue Regulations No. 7-2003 (“RR No. 7-2003”) provides guidelines on the proper determination of whether a particular real property is a capital asset or an ordinary asset. For clarity, Section 3 of RR No. 7-2023 states:
“SEC. 3. GUIDELINES IN DETERMINING WHETHER A PARTICULAR REAL PROPERTY IS A CAPITAL ASSET OR ORDINARY ASSET.
x x x
- Taxpayer not engaged in the real estate business. – In the case of a taxpayer not engaged in the real estate business, real properties, whether land, building, or other improvements, which are used or being used or have been previously used in the trade or business of the taxpayer shall be considered as ordinary assets. These include buildings and/or improvements subject to depreciation and lands used in the trade or business of the taxpayer.
A depreciable asset does not lose its character as an ordinary asset, for purposes of the instant provision, even if it becomes fully depreciated, or there is failure to take depreciation during the period of ownership.
Monetary consideration or the presence or absence of profit in the operation of the property is not significant in the characterization of the property. So long as the property is or has been used for business purposes, whether for the benefit of the owner or any of its members or stockholders, it shall still be considered an ordinary asset. Real property used by an exempt corporation in its exempt operations, such as a corporation included in the enumeration of Section 30 of the Code, shall not be considered used for business purposes, and therefore, considered as capital asset under these Regulations.
Real property, whether single detached; townhouse; or condominium unit, not used in trade or business as evidenced by a certification from the Barangay Chairman or from the head of administration, in case of condominium unit, townhouse or apartment, and as validated from the existing available records of the Bureau of Internal Revenue, owned by an individual engaged in business, shall be treated as capital asset.” [Emphasis and underscoring supplied.]
In essence, when a taxpayer is NOT engaged in the real estate business, only the real properties which are used or being used or have been previously used in the trade or business of the taxpayer shall be considered as ordinary assets. Otherwise, it is a capital asset.
Real Property or Land used by an Exempt Corporation is a Capital Asset
Real property used by an exempt corporation in its operations is classified as a capital asset, not an ordinary asset. Under Section 30 of the National Internal Revenue Code of the Philippines, there is a list of entities which the Bureau of Internal Revenue recognizes as exempt corporations, to wit:
a. Labor, agricultural or horticultural organization not organized principally for profit;
b. Mutual savings bank not having a capital stock represented by shares, and cooperative bank without capital stock organized and operated for mutual purposes and without profit;
c. A beneficiary society, order or association, operating for the exclusive benefit of the members such as a fraternal organization operating under the lodge system, or mutual aid association or a nonstock corporation organized by employees providing for the payment of life, sickness, accident, or other benefits exclusively to the members of such society, order, or association, or nonstock corporation or their dependents;
d. Cemetery company owned and operated exclusively for the benefit of its members;
e. Nonstock corporation or association organized and operated exclusively for religious, charitable, scientific, athletic, or cultural purposes, or for the rehabilitation of veterans, no part of its net income or asset shall belong to or inure to the benefit of any member, organizer, officer or any specific person;
f. Business league chamber of commerce, or board of trade, not organized for profit and no part of the net income of which inures to the benefit of any private stock-holder, or individual;
g. Civic league or organization not organized for profit but operated exclusively for the promotion of social welfare;
h. A nonstock and nonprofit educational institution;
i. Government educational institution;
j. Farmers’ or other mutual typhoon or fire insurance company, mutual ditch or irrigation company, mutual or cooperative telephone company, or like organization of a purely local character, the income of which consists solely of assessments, dues, and fees collected from members for the sole purpose of meeting its expenses; and
k. Farmers’, fruit growers’, or like association organized and operated as a sales agent for the purpose of marketing the products of its members and turning back to them the proceeds of sales, less the necessary selling expenses on the basis of the quantity of produce finished by them;
The properties owned by these exempt entities, if used for their exempt operations, as likewise considered as capital assets.
Evidence to Support a Claim that Real Property or Land is a Capital Asset
Notably, RR No. 7-2003 provides for the evidentiary support that the taxpayer may submit if he or she wants to rebut the presumption that the real property is an ordinary asset.
- The taxpayer may submit a Certification from the Barangay Chairman or from the head of administration which states that the real property, including an apartment, is not used in the trade or business of the taxpayer.
- Furthermore, properties that are classified as ordinary assets due to their use in a business by a taxpayer engaged in a business other than real estate are automatically reclassified as capital assets. This reclassification occurs upon providing evidence that the properties have not been used in the business for more than two (2) years prior to the completion of the taxable transactions involving these properties. Proof of actual use of the property may be presented in many forms, including an affidavit as to its actual use, its declared use for purposes of Real Property Tax, certifications from the government, including the barangay or local government, among others.
- Also, properties classified as ordinary assets for being used in business by a taxpayer engaged in business other than real estate business hereof 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. Proof of actual use of the property may be presented in many forms, including an affidavit as to its actual use, the audited financial statements showing its categorization in the books of the business, certifications from the government, including the barangay or local government, among others.
- Real property that is inherited or received as a gift by an heir or donee, who is not involved in the real estate business and does not subsequently use the property for trade or business, is classified as a capital asset for the heir or donee.
- Real property distributed as dividends to stockholders, who are not involved in the real estate business and do not subsequently use such property in trade or business, is classified as a capital asset for the recipients. This classification holds true even if the corporation declaring the real property dividend is engaged in the real estate business.
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[1] Section 2(b), Revenue Regulation No. 07-2003 (“RR-07-2003”).
[2] Section 2(a), RR-07-2003.
