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When an activity constitutes trading for tax purposes

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Position of IRS

Under sections 162(a)1 and 62(a)(1)2 of the Internal Revenue Code (“Code”), a taxpayer’s adjusted gross income is computed by deducting from his gross income all ordinary and necessary expenses incurred while carrying on a trade or business. The term “trade or business” as used in these sections of the Code has not been defined by Congress or the Internal Revenue Service. The scope of “trade or business” activities has been determined by an ad hoc examination of the facts of each case.

Consequently, courts have reached inconsistent results in their tax treatment of individuals who gamble as the sole means of their livelihood.’ Several courts have denied trade or business status to a gambler because he did not hold himself out as offering goods or services to others.

In St. John’s Law Review [Vol. 61:643 , the Supreme Court held that an individual who earns his living by gambling is engaged in a trade or business if he wagers with “regularity, consistency and an intent to make a profit”, thus refuting the contention that the offering of goods or services to others is necessary to qualify as a trade or business.”

In Groetzinger, the taxpayer devoted approximately 60 to 80 hours per week in 1978 to pari-mutuel wagering at greyhound racetracks and won $70,000 on bets of $72,032.10, however, Groetzinger reported only the $6,498 he received from non-gambling sources as his gross income for the year, did not deduct his gambling losses, and calculated his tax liability accordingly.”

After an audit, the Commissioner determined that Groetzinger’s gross income included his $70,000 in winnings  and that his gambling losses, pursuant to section 165(d) of the Code, could be deducted as an itemized deduction to the extent of his winnings.

The Commissioner further concluded that Groetzinger was subject to the alternative minimum tax provisions of section 56(a) of the Code and that portions of his gambling losses were thereby taxable as an item of tax preference.  Consequently, Groetzinger was assessed on gambling activities.

The Tax Court of United States determined that Groetzinger’s activities were a trade or business within the meaning of section 62(a)(1) as the activities were “sufficiently regular, frequent, active and substantial.’   

Continuity and regularity in carrying on an activity has been properly identified by the Groetzinger Court as a requisite to qualification as a trade or business.

In Flint v. Stone Tracy Co., the Supreme Court construed “business” to encompass a wide spectrum of activities subject to a corporation tax under the Tariff Act of 1909.  The Court held that any activity “which occupies the time, attention and labor of men for the purpose of a livelihood or profit” is a business.

Profitability is a proper criterion of trade or business. In determining whether a taxpayer has an objective intent to make a profit, all relevant facts and circumstances are to be taken into consideration.

The Treasury Regulation provides a list of factors as follows:

1. Manner in which the taxpayer carries on the activity;

2. The expertise of the taxpayer or his advisors;

3. The time and effort expended by the taxpayer in carrying on the activity;

4. Expectation that assets used in the activity may appreciate in value;

5. The success of the taxpayer in carrying on other similar or dissimilar activities;

6. The taxpayer’s history of income or losses with respect to the activity;

7. The amount of occasional profits, if any, which are earned;

8. The financial status of the taxpayer; and

9. Elements of personal pleasure or recreation involved in the activity.

Is Rental Property a Trade/Business

Owning rental property qualifies as a business if you do it to earn a profit and work at it “regularly, systematically, and continuously”. (Alvary v. United States, 302 F.2d 790 (2d Cir. 1962).)

Illustration: Edwin Curphey, a dermatologist, owned six rental properties in Hawaii ande converted a bedroom in his home into an office for his real estate activities. Curphey personally managed his rentals, which included activities such as seeking new tenants, furnishings, cleaning and  preparing the units for new tenants. The court held that these activities were sufficiently “systematic and continuous” to place him in the business of real estate rental. (Curphey v. Comm’r., 73 T.C. 766 (1980).)

Gilford, her two sisters, and other relatives jointly owned eight apartment buildings in Manhattan. They hired a real estate agent to manage the properties and pay each family member their share of the net income. Gilford was found to be in business even though she spent little or no time managing the buildings. The court reasoned that the ownership and management of the buildings was a business because it required considerable time and effort by the real estate agent over several years. Because the agent acted for Gilford and was ultimately under her control, Gilford was in business through her agent. (Gilford v. Comm’r., 201 F.2d 735 (2d Cir. 1953).)

There is no specific number of rental properties or rental units you must own for your rental activity to qualify as a business. In one case, a married couple was found to be engaged in business even though all they owned was a 25% time-share interest in two condominium units. And, the actual work of renting out the units and keeping them in repair was performed by a management company that acted as their agent. (Murtaugh v. Comm’r., T.C. Memo 1997-319.) Indeed, several courts have stated that a landlord who owns a single rental property can be engaged in business. (Balsamo v. Comm’r., T.C. Memo 1987-477.)

Is Rental Property a business/trade or Investment Activity?

Whether you rent a single-family house or a multi-unit apartment building, one of the most important tax issues landlords must deal with is whether your rental activity qualifies as a business or an investment for tax purposes. This distinction between the two classifications has important tax consequences.

Rental ownership is an investment, not a business, if you do it to earn a profit, but don’t work at it regularly, systematically, and continuously, either by yourself or with the help of a manager, agent, or others.

Example: Byron Anderson rented a farm to a tenant farmer. Both the IRS and tax court found that he was an investor, not a business owner, because all he did was pay bills relating to the farm, deposit rent checks, keep ¬records and files for the farm, and talk occasionally with his tenant on the telephone about operating the farm. They found these activities were not sufficiently continuous, systematic, or regular to be a business. (Anderson v. Comm’r., T.C. Memo 1982-576.)

Example: Edgar Grier inherited a house from his mother that she had rented out for many years to the same tenant. This same tenant continued to occupy the property until Grier sold it 14 years later. Over the years, Grier managed the property himself or with the help of an agent. Little management work was required, but Grier did take care of such details as replacing the furnace. The IRS and court found that the house was an investment, not a business for Grier. The court noted that this was the only rental ¬property Grier had ever owned and concluded that his landlord activities were too minimal to rise to the level of a business. (Grier v. United States, 120 F.Supp. 395 (D.Conn. 1954).)

Also, if your rental property is vacant all or most of the time, the IRS could decide that you are an investor, because you wouldn’t need to spend much time dealing with the property.

Finally, people who purchase interests in business entities that own real estate, but are not actively involved in management of the entities, are also investors for tax purposes. These include the limited partners in limited partnerships that own real estate, and people who own shares in corporations and REITs (real estate investment trusts).

Rental Business in Australia-Business or Investment Activity?

In the 2013 Guide for Rental Property Owners, the Australia Tax Office (ATO) reviewed  the tax position of partners carrying on a rental property business.

The ATO gives an example of a couple who jointly own twenty-six residential rental properties. They spend considerable time to manage the properties personally and derive most of their income from rents. The ATO says that they are carrying on a rental property business.

The ATO gives another example of a couple who own three residential rental properties. They manage the properties personally. They both have full-time jobs and derive some rental income. The ATO says that they are property investors.

The ATO’s view is that only if partners are carrying on a rental property business can they agree to share rental income and property losses in different proportions to their legal interests in the property. Otherwise, if the partners are merely investors they must share the rental income and property losses equally.

What is required to carry on a business of letting rental properties in Australia?

YPFD, a taxpayer worked full time as an industrial chemist. She owned nine rental properties jointly with her husband, which had been bought in the 1990s. She used real estate agents to manage the properties. She declared net rental losses of between $27,000 and $57,000 in her tax returns in each of the 2003, 2004 and 2005 years.

The ATO Tribunal applied the six indicia from Smith and the Commissioner of Taxation (2010) 79 ATR 934 as to what activities constitute carrying on a business. The Tribunal formed the overall impression that YPFD carried on a business of letting rental properties, after considering the six indicia:

1. Do the activities have a profit-making purpose?

Tribunal – the intention was to make a profit, even though until now, the properties were loss-making.

2. The complexity and magnitude of the undertaking;

Tribunal – appointing real estate managers was in order – it was not necessary to collect the rents and manage the properties personally.

3. An intention to trade regularly, routinely or systematically;

Tribunal – owning the properties over a period of years since the 1990s was sufficient.

4. Operating in a business-like manner and the degree of sophistication;

Tribunal – the absence of written business plans, and ad hoc advertising for tenants made the taxpayer’s modus operandi unsophisticated and un-business-like;

5. Does a profit or loss arise from a discernible pattern of trading?

Tribunal – there was a discernible pattern of trading in managing the properties.

6. The volume of the operations and the capital employed;

Tribunal – the volume of the taxpayer’s operations and the capital employed were significant.

The taxpayer was therefore carrying on a business of letting rental properties and was allowed to make ‘work related’ expense claims.( culled from http://www.wolterskluwercentral.com.au/legal/property-law/how-do-you-tell-if-youre-carrying-on-a-rental-property-business/)

Position of FIRS

This is clearly stated in its Information Circular What Constitutes ‘Trade’ For Tax  Purposes: Guidelines  For The General  Public published in August 2010.   ‘Trade’ can be regarded as “the business of buying and selling or bartering goods or services”. Where one or more of the criteria on the badges of trade apply, FIRS will treat such transaction as trade. Furthermore, the one-off nature of an activity in no way invalidates that activity as constituting a trade.

Since not all of the incomes of a trading company will necessarily be classified as trading income, the Tax Authorities should release a detailed Guidance Note for taxpayers and advisers to guide them to be able to determine when an activity constitutes a trade. Is it a trade, a business, or an investment activity? The distinction is also important to be treated across the different taxes.

Teju Somorin