Optimizing Capital Gain Results by Documenting the Taxpayer’s Purpose for Holding Assets

Optimizing Capital Gain Results by Documenting the Taxpayer’s Purpose for Holding Assets

By Karen Ritchie and Blake Christian

Key Takeaways:

  • Long-term capital gains associated with assets held for more than one year are generally taxed at a maximum federal rate of 20 percent — not the top ordinary rate of 39.6 percent.
  • While capital gains are generally subject to the additional Net Investment Income Tax (3.8%), a gain on a sale treated as a capital gain is almost always preferable.
  • Documentation of the holder’s intent at acquisition and at the time of sale is critical to securing optimal characterization.
  • The deductibility of net capital losses in excess of $3,000 is generally deferred to future years.
Capital assets vs. ordinary income assets

The Internal Revenue Code (“Code”) oddly defines a capital asset by describing what it is not, rather than describing what it is. For instance, the following “ordinary income” assets are not considered capital assets: inventory, property held for sale to customers, artistic compositions created by the taxpayer’s personal efforts, and accounts or notes receivable acquired or originating in the ordinary course of a trade or business. Assets used in a trade or business that qualify for depreciation, also known as “Section 1231 Assets,” are not capital assets. However, a disposition of such property that results in a gain may enjoy, at least partially, capital gain treatment.

Most other noncash assets are considered capital assets. However, the tax consequences upon disposition are further dependent on whether these assets are held for investment or personal use.

Personal assets

Assets acquired primarily for personal use are generally not purchased with the primary intent of anticipating future appreciation. Nevertheless, if such an asset does appreciate, the gain from its sale is taxed as a capital gain. In the case of a gain on the sale of a personal residence, the capital gain is first reduced by a generous exclusion, in most cases up to $500,000 for joint filers. Losses on sales of personal assets, however, are rarely deductible.

Investment assets

In addition to creating wealth through appreciation, investment assets may also produce a current income stream in the form of interest, dividends, royalties or rents. The most common investments are:

  • Real property
  • Securities
  • Collectibles
Dealer vs. investor vs. trader

In the case of the three asset categories above, whether a holding is considered an ordinary income asset or a capital asset is dependent on each taxpayer’s facts. The distinction requires advisors to evaluate all the factors, and depends primarily on the intent of the owner. Intent is most important at the time of disposition, but asset recharacterization during the holding period may be more closely scrutinized in an audit.

In general, a “dealer” acts as a merchant or middleman, purchasing assets at one price and selling them to customers at a higher price to reflect compensation (“markup”) for risk, handling costs and other services. An “investor” holds property to benefit from the appreciation upon a later disposition. Difficulties arise when a taxpayer acts as a dealer in some transactions and as an investor in others, or acquires an asset with the intent to resell it, only to decide later to retain it as an investment.

Real estate

The case law is well developed in the area of real estate investments, although still extremely subjective, and results vary depending on the particular facts and the court of jurisdiction. Nevertheless, the courts have established the following factors as being key to demonstrating the owner’s intent:

  • Number and frequency of sales
  • Extent of improvements
  • Sales efforts, including through an agent
  • Purpose for acquiring, holding and selling
  • Manner in which property is acquired
  • Length of holding period
  • Investment of taxpayer’s time and effort, compared to time and effort devoted to other activities

Unfortunately, the cases do not lay out a consistent weighting of these general factors.


Works of art, rare vehicles, antiques, gems, stamps, coins, etc., may be purchased for personal enjoyment, but gains or losses from their sale are generally taxed as capital gains and losses. Collectibles are a special class of capital asset to which a capital gain rate of 28 percent applies if the collectible items are sold after being held for more than one year.

Note that recently popular investments in gold and silver, whether in the form of coins, bullion or held through an exchange-traded fund, are generally treated as “collectibles” subject to the higher 28 percent rate. However, gold mining stocks are subject to the general capital gains rate applicable to other securities. Gold futures, foreign currency and other commodities are generally subject to a blended rate of capital gains tax (60 percent long-term, 40 percent short-term).

The difficulties arise when a collector may be viewed as a dealer, or when a dealer sells items from his or her personal collection. Courts have considered the following factors in determining whether sales of collectibles result in capital gain or ordinary income:

  • Extent of time and effort devoted to enhancing the collectible items
  • Extent of advertising, versus unsolicited offers
  • Holding period and frequency of sales from personal collection
  • Sales of collectibles as sole or primary source of taxpayer’s income

An investor acquires securities for his or her own account, resulting in a capital gain or a loss upon disposition. A dealer acquires securities for sale to customers, and recognizes ordinary income or loss on the sale of such assets. A dealer may also hold stock or securities for his or her own investment, but must carefully comply with the regulations under §1.1236-1:

  • Securities held for investment must be clearly identified as such in the books and records before the close of the date of acquisition.
  • A security held for investment must not be held for sale to customers at any time after it has been identified as an investment.
  • Accounting records must segregate the investments from the inventory held for sale, identifying each security by its serial number or symbol.

In the securities area, there is a third category of taxpayer. A “trader” buys and sells securities with great frequency, seeking to catch and profit from swings in the market. Because a trader is acquiring the securities for his or her own profit, and not as a dealer buying and selling to customers, the securities are considered capital assets rather than inventory. Note, however, a trader may likely sell the securities in less than one year, resulting in short-term capital gains and losses. In the alternative, a trader can make a mark-to-market election and recognize unrealized appreciation currently, as ordinary income.

The chief tax advantage of being a trader is the ability to deduct investment trading expenses and interest as ordinary business expenses. An investor is generally subject to limitations on the deductibility of investment interest expense and miscellaneous itemized deductions. Commissions paid in purchasing securities, however, are capitalized as part of the cost of acquiring the securities, and reduce the gain or increase the loss on the ultimate sale of the securities.

A trader’s activity must rise to the level of a trade or business, considering such factors as:

  • Taxpayer’s intent
  • Frequency of trading — regular and continuous trading, almost daily
  • Trading as the sole or primary source of the trader’s income
  • Length of typical holding period
Following is a non-exhaustive list of recommended steps to preserve capital gain treatment:
  • Clearly identify assets held for investment in books and records, segregating them from assets held for sale or development.
  • In the case of collectibles, physically segregate and document the personal collection from inventory held for sale.
  • Memorialize the reason(s) for a change in intent for holding: e.g., death or divorce of principals, legal entanglements, economic changes or new alternate opportunities presented.
  • If a property acquired with the intent to rent is sold prematurely, then retain documentation that supports the decision to sell: e.g., unsuccessful marketing and advertising, failed leases, news clippings of an adverse event or sluggish rental market.
  • If a property is rented out after making substantial improvements, then document all efforts to rent, and list or advertise it for sale only after a reasonable period of rental.
  • Consider selling appreciated/unimproved property to a separate entity before undertaking development. This would necessitate early gain recognition, but may preserve the capital gain treatment on the appreciation that’s realized during the predevelopment period.
  • Consider the application of Section 1237, a limited safe harbor, permitting certain non-C Corporation investors to divide unimproved land into parcels or lots before sale, without resulting in a conversion to dealer status.

Characterizing an asset as ordinary or capital can result in a significant tax rate differential. It can also affect the ability to net gains and losses against other taxable activities. So your clients must spend the time and effort needed to document the intent of the acquisition of an asset, as well as any facts that might change the character of the asset, during the holding period.

About the Author

Karen Ritchie is a Tax Principal and Blake Christian is a Tax Partner with HCVT, LLP, a Top 50 CPA Firm with offices in California, Texas and Utah. They can be reached at: karen.ritchie@hcvt.com and (310) 566-6804 or blakec@hcvt.com and (562) 216-1800, respectively.