Investor vs Dealer - Example

[Eric Williams]

So a piece of property in terms of capital or ordinary treatment, relies heavily on the items intended use in the taxpayer's hand.

It can turn an otherwise capital gain into an ordinary one. It may even disallow previous amounts. And the IRS does do this.

Here are some factors from a case.

In determining whether the income should be classified as ordinary income or capital gain, the court evaluated nine criteria: 

(1) the taxpayer’s purpose in acquiring the property; 

(2) the purpose for which the property was subsequently held; 

(3) the taxpayer’s everyday business and the relationship of the income from the property to the taxpayer’s total income; 

(4) the frequency, continuity, and substantiality of sales of property; 

(5) the extent of developing and improving the property to increase sales revenue; 

(6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales;

(7) the use of a business office for the sale of property;

(8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property; and 

(9) the time and effort the taxpayer habitually devoted to sales of property. It is important to note that, under Sec. 1221(a)(1), property is not a capital asset if it is “stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer . . . or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

It is key you be able to demonstrate both intent at the time of the transfer, and in activities after, especially if you churn. From the case:

During the trial, Mr. Flood argued that the lots were purchased for investment purposes and therefore the profits should be taxed as capital gains. However, the court found that even though the Floods did not develop the lots or use a business office, they put considerable effort into the real estate. The Floods examined public records to determine which property owners to contact to purchase the lots, mailed letters to the property owners to facilitate their purchase of the lots, prepared agreements for execution, prepared deeds, paid legal fees to clear title to properties they purchased, paid legal fees to ensure the closing of the properties, paid legal fees to enforce specific performance of purchase-and-sale agreements, conducted research, made phone calls, and used a real estate agent to sell lots. Additionally, Mr. Flood created a website designed to sell the lots and place advertisements in public places. The court also considered that the income the Floods derived from other sources was modest compared with the sale of the lots.

The court concluded that the “preponderance of credible evidence supports a conclusion that the Floods’ real-estate transactions were conducted in the ordinary course of a trade or business and not for investment purposes