Pillars of Capital Gains Treatment 

May 4, 2018

One of the fundamental distinctions in taxation is the distinction between ordinary income and capital gain. In general, ordinary income is any income from typical business activities.  Capital gains, meanwhile, results from investment activities. If you generate income from a business you own, or earn money as employee wages, it is ordinary income.  If you sell a “capital asset,” such as a bond or other investment instrument, however, this income is a capital gain. In many cases, the distinction between these two types of income is pretty straightforward.  There’s not too much room for debate as to the proper classification. However, in some instances, there can be uncertainty.

Ordinary Income or Capital Gains?

The issue of whether income should be classified as ordinary income or capital gains is very important.  These classifications affect tax treatment. If you sell a capital asset, let’s say, corporate stock, your tax is a capital gains tax. In this article, we’ll discuss the contours of capital gain treatment.  We’ll do so by examining how such treatment can be affected by the manner which an asset is held.  We’ll then look at the so-called “7 pillars” of capital gains treatment.  They’ll provide us with guidelines for determining treatment in any given case.  

Holding Affects Capital Gains Tax Treatment 

As mentioned, capital gains treatment follows whenever an individual or business entity sells a capital asset. The determination of whether a given piece of property qualifies as a capital asset is not simply based on identity.  The particular manner in which the property is held is also relevant. For instance, stock in a corporation is typically a capital asset.  That’s because stock is usually held as an investment. When most people buy stock, they buy it with the intention of holding it as an investment.  Most people hope that it’ll eventually yield them a high return. But, suppose that someone were to receive stock as wages.  Is the stock still a capital asset in this scenario? In such a case, the stock would actually be taxed initially as ordinary income.  That’s because it was received as compensation for work performed in the course of employment. 

Real Estate

Likewise, real estate is typically held as an investment.  Real estate investors are often saddled with large capital gains tax liabilities when they ultimately sell it. But, again, a critical factor in determining capital gains treatment is the way in which the property is held.  Accordingly, if someone buys real estate and then treats the property as their primary residence, they won’t receive capital gains treatment on its sale. The key point to take away is that capital gains treatment is determined by investor actions rather than the identity of the property.  

Byram v. United States

In some cases, there can be disputes as to the proper classification of a given source of income. Fortunately, case law provides some level of guidance through uncertainty.  This can help those who may be uncertain about how to categorize their income. The case of Byram v. United States (1983) provides just such guidance.  Byram is a well-known piece of litigation which helped to clarify the distinction between ordinary income and capital gains. In making its decision, the Byram court referenced the 7 pillars of capital gains treatment.  That is, the 7 factors to consider when analyzing a given dispute.  

In the Byram case, an investor sold a total of 22 pieces of real estate.  He did so over a two-year period, between 1971 and 1973. During that time, he didn’t keep a business office.  He also didn’t actively advertise his real estate for sale, engage a broker, or subdivide his real estate.  Furthermore, all of the transactions were initiated by the buyers. Given the time period involved, as well as his profits,  he profited approximately $3.4 million from all sales combined, the IRS had reason to argue that Byram was actually engaged in a formal business.  As a result, the IRS held that his  income should be classified as ordinary income.  

The 7 Capital Gains Pillars 

In its analysis, the Byram court identified 7 pillars of capital gains treatment.  They are as follows:

(1) The basic purpose of acquiring the assets and the duration of ownership.

(2) The amount of  effort put into selling the assets.

(3) The number, extent, magnitude and overall continuity of the sales.

(4) The time and energy devoted to developing the assets and advertising to increase the volume of sales.

(5) Whether the taxpayer used a business office when making the sales.

(6) The level of supervision exercised by the taxpayer over any representative involved with selling the assets.

(7) The total amount of time and energy devoted to making the sales. 

The Byram court, in this case, the Fifth Circuit Court of Appeals, affirmed the trail court ruling in favor of Byram. Specifically, that Byram’s behavior in the years 1971 – 1973 supported the determination that his income should be classified as capital gains, not ordinary income. Even though he sold the real estate over an extended period, his actions did not support the idea that he was engaged in a formal business.  

Call a NYC Tax Attorney For Help

Ordinary income and capital gains are two fundamental concepts in the field of tax. Again, determining which category your income falls into is very important.  That’s because these categories impact your tax liability. As we see, there are numerous factors which courts look at when deciding a tax classification in any given case. If you have an issue relating to capital gains treatment, or any other tax issue, please call.  Don’t hesitate to reach out us here at Mackay, Caswell & Callahan, P.C.  Give us a chance and a top NYC tax attorney will assist you with your case! 

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3 Useful Tax Avoidance Strategies | New York Tax Attorney 4 years ago

[…] another example of tax avoidance would be holding investment property to receive favorable tax rates. If you acquire property for investment purposes, you will pay specialized rates when selling the […]

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3 Useful Tax Avoidance Strategies | New York Tax Attorney 4 years ago

[…] another example of tax avoidance would be holding investment property to receive favorable tax rates. If you acquire property for investment purposes, you will pay specialized rates when selling the […]

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