We have argued

[jainen]

We have argued about this topic several times -- Is building a spec house for sale an investment or a business? I've always said it is a business because most of the profit comes from the owner's activity rather than from holding the property for market appreciation.

Now that I have an actual client of my own, I'm not so dogmatic. I need to cite some authority for either side. Does anyone know a code section or reg that defines investment in such a scenario, or an example in a pub or court case that demonstrates treatment as a business?

[Black Bart]

The big argument

on that stuff was Snaggletooth's "1099" post of 12-16-06 (may be some cites in there).

[OldJack]

If there are any good cites they are probably within the past argument posts.

[RLymanC]

Home Construction

Try this site, it may help.

http://www.irs.gov/businesses/small/industries/article/0,,id=97934,00.html

[JG EA]

The best information ever on this subject I’ve read was a post by BK and JV in the old QF days. I don’t have it here at home and I’m sure I won’t do it justice.

Their point was: would someone want to be paid for their work, their efforts, as opposed to investing money into something to have that money work for you. If they would want to be paid for their work (for instance - if they were doing this for someone else) it’s a business…

Another point they made: is something bought because of specialized business connections (like a storeowner buying items for resale) then the thing purchased is more like inventory than an investment – therefore a business.

They put it all so much better so that I could really understand it.
__

There is also other things to keep in mind – there are extensive regulations on how many years to keep subdivisions so as not to be viewed as a business – therefore it seems that the default is a business.

Also keeping in mind the hobby aspect – does your client only intend on doing this “project” once and so clearly not in the business of…?

[jainen]

one or another factor

Thanks for all the suggestions. There are several positions supported by good reasoning, but not much in actual citations. The best is the Maddux Construction court ruling.

Maddux said "several factors have been enumerated" but didn't say how to apply them. It does differentiate between "operation" and "appreciation," which is similar to JG's point and consistent with my previous arguments. Investment refers to property held for a significant period of time.

It seems that the number of sales is very important, but no one factor is decisive. Improvements and sales efforts are likewise very important, as is the source of other support.

One new item I came across is the observation that favorable capital gains treatment is an exception to the general rule of income taxability, and therefore it can't be simply assumed just because one or another factor is not present.

[LTS]

4797/Sch D

We have argued about this topic several times -- Is building a spec house for sale an investment or a business? I've always said it is a business because most of the profit comes from the owner's activity rather than from holding the property for market appreciation.

I think, whether it is a business or investment spec house sale at a gain, the tax ends up the same. Sort of like the discussion a short time back about putting land on ptI of 4797, or lumping it with the building in ptIII - same/same by the time it goes to the Sch D.

It is a different discussion if the sale is a loss over 3000, or the seller is a real estate dealer, but i don't think that is the case here?

[OldJack]

JG makes some very good points of logic, however, we all know that logic has little to do with the tax code and regulations.

LTS makes a good point regarding sometimes it makes little difference, but actually there can be a huge difference in tax treatment between code §1221 asset (1040 Sch-D) and §1231 (F4797). Also, the type of entity is important as if it is a C-corp it makes little difference as there is no max tax rate, but it could make a difference if the C-corp has a capital loss carryforward that is about to expire.

If the property is §1221 (capital asset) the gain is definitely taxed at the max tax rate for capital gains or less. If it is §1231 (business asset) it is first subject to ordinary income if form 4797 losses have occurred in the past 5 years (Nonrecaptured net section 1231 losses from prior years, line 8 ). If the taxpayer has had prior year losses more than the gain, the entire gain will be taxed at ordinary income tax rates of the taxpayer.

Therefore, a tax practitioner should give serious consideration to the concept that the taxpayer is holding the asset as an investment under the tax code and not as a business. As to improving the property... I have never found tax cites that say improving an asset turns the taxpayer into a businessman, however, planning and intent of use certainly can.

edit: One word of caution... the taxpayer at an audit will shoot himself in the foot with some statement that acknowledges he is in business.

[jainen]

I can't say

>>I have never found tax cites that say improving an asset turns the taxpayer into a businessman<<

That's a bit disingenuous, Jack. Every court case refers back to Maddux Construction v. Commissioner. That old ruling clearly stated that "the extent to which improvements, if any, were made to the property by the taxpayer" is one of the most important issues.

In fact, it was the key question in that case. Maddux was a real estate builder that acquired the property for development and sale. The court agreed that the company's intentions changed, as evidenced by the complete lack of construction.

True, facts that prove it is investment property are not the same as facts that prove it is not. There are many cases like Maddux -- taxpayers who are already in business but also hold investment property. I haven't found a single case where someone claims investor status because they are not otherwise in the business. I suppose that means nobody has ever had a good enough argument to take to court. But whether that nobody was the taxpayer or the IRS, I can't say.

[OldJack]

Of course Jainen you are correct that the extent of improvements are one issue in the determination as is most everything about the taxpayer and his intentions with the property. However, as you say in that case it was one of the most important issues, I have not read the case you cite or if I have it was a long time ago. My point was that improving the property does not in itself automatically or logically make it a business operation. Taxpayers improve capital assets all the time without the asset being classified as a business asset. ie: a residence is in reality a capital asset, a personal customized vehicle is a capital asset, etc.

As LTS pointed out, if when you analyze the taxpayer's tax return and if it makes no difference then it really doesn't matter how you treat it unless it will happen again. If treated as a business it would certainly not raise a red flag since the IRS would only want it as investment if it had a loss. And yes... don't think the IRS would not claim either way if it was to their benefit. Also, if it is a short-term gain it may make no difference.

Maybe you should look to the definition of a "trade or business". My little 2007 RIA handbook, paragraph 1776, says:

"A trade or business is a pursuit or occupation carried on for profit whether or not profit actually results. An isolated transaction isn't a business. Taxpayers may engage in one business, in more than one business, or in no business. Merely investing in corporations, however actively, isn't a business."..... "For a transaction involving property, taxpayer must intend to receive income from it or to profit from disposing of it."

I think it unlikely that any of our clients would hold and or improve real property as a hobby so I don't see that as an issue.

[OldJack]

As to the tax code in your clients case:

Code §1221 defines a capital assets (Sch-D reporting) by saying:

the term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include -
(1) 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 property held by
the taxpayer primarily for sale to customers in the ordinary
course of his trade or business;
(2) property, used in his trade or business, of a character
which is subject to the allowance for depreciation provided in
section 167, or real property used in his trade or business;
(3) a copyright, a literary, musical, or artistic composition,
a letter or memorandum, or similar property, held by -
(A) a taxpayer whose personal efforts created such property,
(B) in the case of a letter, memorandum, or similar property,
a taxpayer for whom such property was prepared or produced, or
(C) a taxpayer in whose hands the basis of such property is
determined, for purposes of determining gain from a sale or
exchange, in whole or part by reference to the basis of such
property in the hands of a taxpayer described in subparagraph
(A) or (B);

(4) accounts or notes receivable acquired in the ordinary
course of trade or business for services rendered or from the
sale of property described in paragraph (1);
(5) a publication of the United States Government (including
the Congressional Record) which is received from the United
States Government or any agency thereof, other than by purchase
at the price at which it is offered for sale to the public, and
which is held by -
(A) a taxpayer who so received such publication, or
(B) a taxpayer in whose hands the basis of such publication
is determined, for purposes of determining gain from a sale or
exchange, in whole or in part by reference to the basis of such
publication in the hands of a taxpayer described in
subparagraph (A);

(6) any commodities derivative financial instrument held by a
commodities derivatives dealer, unless -
(A) it is established to the satisfaction of the Secretary
that such instrument has no connection to the activities of
such dealer as a dealer, and
(B) such instrument is clearly identified in such dealer's
records as being described in subparagraph (A) before the close
of the day on which it was acquired, originated, or entered
into (or such other time as the Secretary may by regulations
prescribe);

(7) any hedging transaction which is clearly identified as such
before the close of the day on which it was acquired, originated,
or entered into (or such other time as the Secretary may by
regulations prescribe); or
(8) supplies of a type regularly used or consumed by the
taxpayer in the ordinary course of a trade or business of the
taxpayer.

Therefore, the only thing in your case that might make it business property is item 1 since there is no business "use" to be concerned about item 2. If you can get past item 1 you do not have business property.

[outwest]

Okay, time for real research I guess.

We have argued about this topic several times -- Is building a spec house for sale an investment or a business? I've always said it is a business because most of the profit comes from the owner's activity rather than from holding the property for market appreciation.

?

Well, let's start from the issue of Self Employment tax levied on the income from a trade or business
>>
The phrase "trade or business" has been in section 162(a) and in that section's predecessors for many years. Indeed, the phrase is common in the Code, for it appears in over 50 sections and 800 subsections and in hundreds of places in proposed and final income tax regulations. The slightly longer phrases, "carrying on a trade or business" and "engaging in a trade or business," themselves are used no less than 60 times in the Code. The concept thus has a well-known and almost constant presence on our tax-law terrain. Despite this, the Code has never contained a definition of the words "trade or business" for general application, and no regulation has been issued expounding its meaning for all purposes. Neither has a broadly applicable authoritative judicial definition emerged. Our task in this case is to ascertain the meaning of the phrase as it appears in the sections of the Code with which we are here concerned.
Commissioner v. Groetzinger, KTC 1987-123 (S.Ct. 1987)

<<

So there is our first problem, this frequently used phrase has no real definition. There is no bright line definition. So now we end up with facts and circumstances guidance and going to court cases like the above.

for a summary of the arena: Per Klienrock analysis
>>A taxpayer is engaged in a trade or business if involved in an activity with continuity and regularity and the primary purpose of that activity is for income and profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.

The term "trade or business" has the same meaning as under Code Section 162, relating to the deductibility of trade or business expenses. [31] In general, an individual is considered to be engaged in a trade or business if he is regularly and continuously engaged in an activity, the primary purpose of which is to realize an income or profit. [32] Managing investments, regardless of the level of activity, is not carrying on a trade or business
<<

In support of those who say a one time buy, fix up and sell is not a trade or business, take a look at Rev Rul 58-112, 55-431, and 77-356. For example, one taxpayer that worked 4 weeks as a carpenter after hours did not become a trade or business. But if you develop some regularity to this activity, now you may have a business. (I've used these as rational for some one shot deals with my clients)

It's interesting to me that I didn't find any litigation on contractors as a trade or business vs capital gains. I think that is because it is well settled that it is a business . If fact, much of the code and regulations deals with proper costing (completed contract vs percentage of completion methods for example) in the context of a business. The closest litigation I could find concerned a guy that would buy distressed businesses (I would sub the word "homes") and fix them up to sell. Farrar v. Commissioner, T.C. Memo 1988-385
Oddly enough, the taxpayer was arguing for trade or business treatment to allow him to deduct expenses and losses, the IRS for capital treatment to limit those deductions. Anyway the court ruled in favor of a business treatment though that still did not permit some of the deductions.

So we reach the end of this with no clear citation under a microscope. But I think if we step back, the overall picture looks like this:

People that construct buildings or fix them up are in business.
Developers are in business.
Developers that buy land and hire others to construct buildings for sale are in business.
Regularity and continuity are key factors in a business.
A one shot deal may have a small window for investment treatment.
Tax law is an art, not a science, sometimes without a bright line to use.

[OldJack]

>>People that construct buildings or fix them up are in business.
Developers are in business.
Developers that buy land and hire others to construct buildings for sale are in business.
Regularity and continuity are key factors in a business.
A one shot deal may have a small window for investment treatment.
Tax law is an art, not a science, sometimes without a bright line to use.<<

True... the people you cite may or are in fact "in business", however, that does not mean that they cannot hold property as an investor or as a capital asset. In my previous cite of code §1221 note the words "the term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business),"

It is possible for someone that is in a trade or business (be it a partnership, a corporation, or individual) to hold property owned by the business but it not be classified as code §1231 business property. It is the tax status of the property... not necessarily the tax status of the owner that controls the taxation of the property.

edit: That is why there is a 1120-SchD, a 1120S-SchD, a 1065-SchD, a 1041-SchD, and a 1040-SchD. Also, note that form 4797 (§1231 business assets ) works with all tax entities.

[outwest]

No argument with me..

that a business can own capital assets.

On the other hand, real estate held for sale in the normal course of business in the hands of the developer is inventory, not a capital asset. If fact, even if the property would be a capital asset in the hands of the buyer. Even though real estate and depreciable property or many other things might normally be 1231 property, 1231 excludes Inventory, stock in trade, and property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business.

Now I can imagine a scenario that a developer might construct a property then hold for investment, (heck, I even vaguely recall a case like that) but I think you would be swimming upstream against fast water.

Code Section 1231:
(1) GENERAL RULE

The term "property used in the trade or business" means property used in
the trade or business, of a character which is subject to the allowance
for depreciation provided in section 167, held for more than 1 year, and
real property used in the trade or business, held for more than 1 year,
which is not--

(A) property of a kind which would properly be includible in the
inventory of the taxpayer if on hand at the close of the taxable
year,

(B) property held by the taxpayer primarily for sale to customers in
the ordinary course of his trade or business,

[OldJack]

Now I can imagine a scenario that a developer might construct a property then hold for investment, (heck, I even vaguely recall a case like that) but I think you would be swimming upstream against fast water.

Exactly! It is facts and circumstances that determine the tax status of real property. Too often we tax professionals automatically jump to conclusion and decide a tax status without finding out the intent and facts of the case with the taxpayer (swim down stream?). And you know the taxpayer seldom tells us all the facts.

As professionals we owe it to the taxpayer to make the right determination and calculate the correct tax, be it as business property or capital asset property. We would be foolish to swim up stream or down stream to a tax position that can't really be justified if questioned. Justification is not just for proof to the IRS, rather it is also for the taxpayer.