The tax code draws a distinction between ordinary income and income derived from the sale of a capital asset, or “capital gain.” In most instances, this distinction is straightforward and there is little confusion about whether income falls into one category or the other. Every now and then, however, a situation develops in which the classification of income is a difficult matter. There is much at stake in the determination of whether income is either ordinary or derived from the sale of a capital asset: capital gains can be taxed at substantially lower rates than ordinary income.
The case of Byram v. United States (1983) provides one example of the difficulty occasionally involved in distinguishing between a “business” sale – which would trigger ordinary income – and an investment sale. The tax code recognizes a number of general characteristics of business sales and investment sales; sometimes a transaction possesses characteristics of both a business sale and an investment sale, or it lacks enough characteristics of one type of sale to merit a definitive classification.
If you engage in real transactions with any kind of regularity, be sure that you’re aware of these characteristics so you can avoid any unpleasant surprises when tax time rolls around.
John Byram owned multiple pieces of real estate. Between the years 1971 and 1973, Byram sold a total of 22 pieces of real estate for a gross return of $9 million and a net profit of $3.4 million. He sold 7 pieces of real estate in 1973 alone.
Importantly, Byram did not have a business office; he did not advertise; he did not utilize the services of a broker; he did not subdivide the land; he spent only a small amount of time and effort engaging in the transactions; all of the transactions were initiated by the purchasers.
The question of whether a transaction – or set of transactions – can receive “capital gain treatment” (and therefore be subject to the rates applicable to capital gains) depends on the characteristics of the transaction. Courts recognize the 7 “pillars” of capital gain treatment when deciding whether a given transaction should be deemed either an investment sale or business sale.
The 7 Pillars of Capital Gain Treatment can be summed up as follows: (1) purpose of the acquisition of the property and duration of ownership; (2) extent of the efforts to sell the property; (3) number, extent, continuity and magnitude of the sales; (4) time and effort devoted to developing the land and advertising to increase sales; (5) use of a business office; (6) degree of supervision exercised by the owner over any representative selling the property; (7) overall time and energy dedicated to the sales.
The question before the court was: do the transactions made by Byram between 1971-1973 merit capital gain treatment based on the guidelines established through the 7 pillars?
The court (the Court of Appeals for the Fifth Circuit) affirmed the ruling of the lower court in favor of Byram. The transactions engaged in by Byram (and his buyers) possessed enough characteristics of an investment sale to trigger capital gain treatment. The determination of whether capital gain treatment is warranted requires an independent analysis for each individual case; in the Byram case it was clear that the evidence supported the conclusion that the properties were not sold as part of a business enterprise but as investments.
The Byram case is highly useful for people who own multiple pieces of real estate and who are considering selling these pieces in the future. It is important for these owners to be conscious of the facts of Byram so that they can be certain to receive capital gain treatment.
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Readers who enjoyed this essay should check out our presentation of the tax benefits of real estate ownership by CPA Jessica Chisholm