Ordinary income

Definition

Ordinary income refers to the earnings generated from a taxpayer's regular business activities or other sources, such as wages, salaries, and rental income. This type of income is subject to standard income tax rates and is distinct from capital gains, which arise from the sale of assets. Understanding ordinary income is essential for tax planning and compliance, especially for entities involved in real estate investment and management.

5 Must Know Facts For Your Next Test

1. Ordinary income is taxed at progressive rates, meaning that higher income levels are taxed at higher rates compared to capital gains, which may be taxed at a lower rate.
2. Common sources of ordinary income include salaries, wages, rents from properties, and business profits.
3. In the context of REITs, ordinary income primarily comes from rental income and interest earned from properties they own or finance.
4. To qualify as a REIT and avoid taxation at the corporate level, it must distribute at least 90% of its ordinary income to its shareholders.
5. Ordinary income can affect an investor's overall tax liability and investment strategy since different types of income are treated differently under tax law.

Review Questions

• How does ordinary income differ from capital gains in terms of taxation?
  • Ordinary income is taxed at regular income tax rates that are progressive, meaning they increase with higher income levels. In contrast, capital gains are usually taxed at lower rates because they arise from the sale of assets rather than active business earnings. This difference in taxation can significantly impact an investor's overall tax burden and investment decisions, particularly when considering real estate investments and potential profit distributions.
• Discuss the importance of ordinary income for Real Estate Investment Trusts (REITs) and how it influences their tax obligations.
  • Ordinary income is crucial for REITs because it primarily comes from rental income generated by their properties. To maintain their status as tax-exempt entities at the corporate level, REITs must distribute at least 90% of their ordinary income to shareholders in the form of dividends. This requirement not only influences their operational strategies but also affects investors' returns since a significant portion of earnings must be paid out rather than retained for reinvestment.
• Evaluate the implications of ordinary income on an investor's overall tax strategy in real estate investments.
  • The treatment of ordinary income can have profound implications on an investor's tax strategy when dealing with real estate. Since ordinary income is subject to higher tax rates compared to capital gains, investors might strategize on timing their sales or opting for properties that generate favorable tax treatment. Additionally, understanding how REIT distributions are classified can help investors make informed decisions regarding their portfolio management and expected returns, maximizing after-tax benefits.

Related terms

Capital Gains: Capital gains are the profits earned from the sale of an asset, like real estate or stocks, when the selling price exceeds the purchase price.

Taxable Income: Taxable income is the amount of income that is subject to taxation after deductions and exemptions are applied.

Real Estate Investment Trust (REIT): A REIT is a company that owns, operates, or finances income-producing real estate and must distribute at least 90% of its taxable income to shareholders in the form of dividends.