Trading domain names - business or investment?
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evil_shenanigans
Level 3

Trading domain names - business or investment?

I have a side gig speculating in domain names. This entails:

 

  • Looking for unregistered domains that I think have value
  • Valuing domains using various websites
  • Registering and renewing the domains, generally for multiple years
  • Listing the domains for sale on online brokerages
  • Negotiating with buyers
  • Transferring domains to the buyer

 

A couple of questions:

 

  1. Should I consider this a (Schedule C) business, in which the domain names are my inventory? Or are my domain names investments that would generate capital gains/losses rather than business gains/losses?
  2. At this point, I've retired from searching for new names for several years. Now I just maintain my existing inventory and very occasionally sell a domain (e.g., maybe one a year). Does this change the situation? (E.g., does this mean I'm no longer an "active" participant in the business?)
11 Replies
martinmarks1919
Level 8

Trading domain names - business or investment?

You have to make the call whether this is a business or an investment or a hobby.....depends on your intent and other factors.

Opus 17
Level 15

Trading domain names - business or investment?

Here are some guides to whether an activity is a business or hobby.

https://turbotax.intuit.com/tax-tips/small-business-taxes/when-the-irs-classifies-your-business-as-a...

https://www.irs.gov/faqs/small-business-self-employed-other-business/income-expenses/income-expenses

 

You are a business if you are engaged in an "ongoing trade or business" meaning you do things that businesses do; you seek out new customers, you try to make a profit, you advertise, and generally act in a "businesslike manner".  There is rarely a black and white distinction, it is the overall culmination of factors.

 

It's not a question of whether you are an active or passive participant in your business, but whether you are a business at all.

 

Then, there is a separate question over when an investor/day trader performs so much trading activity that they can be considered self-employed and use a schedule C to deduct expenses.  (The profit and loss from capital investing is still reported on schedule D, but a trader who makes trading their "business" can sometimes deduct other expenses like an office, computer, and expenses for doing investment research.)

 

Buying and selling property (which this is, even though the property is intangible) creates capital gains and losses which are reported on schedule D.  Nothing happens on your tax return when you buy something.  When you sell it, you have a capital gain or loss.  You have a gain if you sell the property for more than you paid for it (your adjusted cost basis).  If you have carrying expenses in the mean time, you can "capitalize" your expenses (add them to your cost basis) but this sometimes requires sending a written statement to the IRS each year attached to your tax return explaining what costs are being capitalized to which property assets.

 

(A simple example is buying a vacant lot for investment purposes and hoping to sell it later.  In the mean time, you pay property taxes and expenses to keep the lot cleared and free of other people's trash.  You generally can't deduct those expenses on schedule C because you aren't an active enough investor to use a schedule C.  But you can capitalize the expenses by adding them to the cost which reduces your taxable gain when you sell.  This requires attaching a statement to your tax return.  Domain names seem similar in concept.)

 

Based on your statement, you probably would not qualify to use schedule C for your expenses.  If you sell any domains, you have a capital gain on schedule D.  Whether you can capitalize your annual carrying costs without having previously reported an election to do so on previous tax returns would  require a professional to advise you.

 

How have you reported income  and paid taxes on the domains you previously sold?

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*
evil_shenanigans
Level 3

Trading domain names - business or investment?

@Opus 17- thanks as always for your detailed response! Yes, I've previously treated this activity as a Schedule C business. I've reported sales income and managed expenses as inventory (i.e. cost of goods sold).

 

After reviewing the links you sent, I'd say it's still a bit murky whether this qualifies as a business or not.  Certainly my intention was to make a profit, but I pretty quickly (within a few months) gave up actively pursuing this activity when I realized it was taking much more time than I anticipated and thus the cost-benefit analysis didn't add up for me. Since that time, 2016 I think, I've just basically sat on the domains and still occasionally sell one when somebody finds it on a brokerage site. Due to essentially random fluctuation, some years I have a net profit and some a net loss.

 

Here are the IRS criteria and my response to them:

 

  • Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records. [Yes. My records are impeccable.]
  • Whether the time and effort you put into the activity indicate you intend to make it profitable. [Unclear. I invested considerable time and effort for several weeks/months at the outset, and little since.]
  • Whether you depend on income from the activity for your livelihood. [No]
  • Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business). [Unclear. My losses are just due to registration costs in years where I didn't happen to sell enough domains to make up for them.]
  • Whether you change your methods of operation in an attempt to improve profitability. [Unclear. I didn't really stick with it long, but arguably I did this by exploring different auction sites / brokerages to list the domains on.]
  • Whether you or your advisors have the knowledge needed to carry on the activity as a successful business. [Unclear. I guess not since I don't really make any money.]
  • Whether you were successful in making a profit in similar activities in the past. [NA]
  • Whether the activity makes a profit in some years and how much profit it makes. [Yes. Not much -- a few hundred bucks at the most.]
  • Whether you can expect to make a future profit from the appreciation of the assets used in the activity. [Unclear, to me at least, if domain name values are appreciating.]
Opus 17
Level 15

Trading domain names - business or investment?

I think that, regardless of how you operated in the past, by your own admission it's not a business any more.  I don't think you should file a schedule C, and you can't deduct expenses like the annual domain registration renewal fees or a home office.  Since the domains are "property" you would report their sale on schedule D as capital gains property.

 

I tried to figure out if you could capitalize your carrying costs under section 266 and I just don't know.  Most articles about section 266 focus on real estate, and while some parts of section 266 refer to real property, other places just say "property."  But the tax reform law of 2018 also affected section 266.  So the bottom line is I just don't know.  You would have to get professional advice if you want to find some way to deduct your carrying costs.

https://www.law.cornell.edu/cfr/text/26/1.266-1

 

(For example, suppose you bought gold as an investment and paid someone to store it in a vault.  Under the old law, the storage fees were a deductible expense as itemized miscellaneous deductions subject to the 2% rule.  Your domain registration fees would have been deductible under the same theory, assuming you were holding the domains as investments and not able to deduct the expenses on schedule C.  The TCJA of 2018 eliminated the misc itemized deduction.  So now, the question is that when section 266 says "you can elect to capitalize expenses that would ordinarily be deductible" can you still elect to capitalize your carrying costs, or are they not eligible for section 266 because they are no longer deductible as itemized deductions.  The IRS has not ruled on this question, apparently.)

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*
evil_shenanigans
Level 3

Trading domain names - business or investment?

Thanks @Opus 17. To clarify your discussion of the capitalization, if I consider these domains as Schedule D investments, what happens in the following scenario?

 

Let's say I buy a domain name in 2015 for $10, and renew it each year from 2016 to 2019 for $10 each year. Then I sell it in 2020 for $100.

 

2015: ($10)

2016: ($10)

2017: ($10)

2018: ($10)

2019: ($10)

2020: $100

 

Are we saying here that, depending on how we interpret the 2018 tax reform law, it's possible I can't recover the 2016-2019 costs at all? So when I sell in 2020, my cost basis would be $10 (i.e., what I originally paid in 2015), and I would pay capital gains on $90, instead of $50?

 

Certainly it feels intuitively wrong that I owe tax on (almost) the full sales price without any recognition of all the registration costs over the intervening years. Do you think that's the case? Perhaps the solution is that these additional registration costs are not really carrying costs but somehow part of the purchase price? (Arguably I am purchasing the domain over and over when I re-register it, so maybe the value is the total amount I've paid? The last amount I paid?) Or, conversely, does the existence of these carrying costs at all imply that perhaps it is a schedule C business after all? (I guess not, since I don't see that in any of the IRS criteria for distinguishing business from hobby.)

 

Yikes.

Opus 17
Level 15

Trading domain names - business or investment?

So, let me talk about capitalization for a minute.

 

If you owned real estate as an investment, prior to 2018, you could choose to deduct your carrying costs as an itemized miscellaneous deduction subject to the 2% rule, or capitalize your costs (add them to the cost basis). Capitalizing costs required attaching a written statement to your tax return each year that you had costs to capitalize.  (These costs would mainly have been utilities and maintenance, since all your property taxes were already deductible on schedule A.)

 

You could also deduct (as a misc itemized deduction subject to the 2% rule) the carrying costs for other investments of property (property in this case meaning anything that you can own and hold title to, where "real property" is a specialized term meaning land and anything that is permanently attached to the land).  So you could, for example, deduct the cost of a safe deposit box in which you stored gold coins you bought as investments.  Intellectual property (e.g. domain names) would have been allowable as property.

 

Now, the first problem is that I don't know for certain that you could elect to capitalize carrying costs on non-real property.  The code just says "property" but the examples given are all for real property.  I think you could capitalize carrying costs on other types of investment property but I am not a tax attorney.

 

The second problem is that, even if the election is allowed for a domain name, it would have to have been made on every tax return since you bought the property.    And the third problem is that section 266 says you can choose to capitalize costs that would have been deductible; and since the tax reform act eliminated the miscellaneous itemized deduction, the carrying costs aren't deductible.  So section 266 might no longer apply, but the IRS has not issued a ruling.

 

----------

Now, separately, if you were reporting your domain name trading as a schedule C business, you should have deducted your carrying costs as business expenses in the year the expense occurred.  (Or you had the option of capitalizing them, but it would almost always have been better to deduct them as business expenses.)  

 

----------

So in your example, were you a schedule C business at some point?  And when did you stop filing a schedule C?  Because if you were a schedule C business in 2015, 2016, and so on, you should have already deducted your cost as well as your annual registration fees, and you can't deduct them again.

 

Then when you stopped being a business and started being a hobby, you would have had to make the written section 266 election on each tax return after that.  You could have made the election for tax years up to 2017, so only your 2018 and 2019 costs would have been lost.  

 

I don't know if you can file an amended return at this point to make the election for prior years where it would have been definitely allowed (up through 2017).  You can probably amend tax returns that are within the 3 year amending deadline (2017, 2018, 2019), but I don't know if you can amend earlier than that to make the election.  You would make the section 266 election and hope you don't get questioned.  

 

Or, you could go back to being a business which would allow you to deduct your expenses in the year you paid them.  That might also mean filing extensive amended returns to add a schedule C showing zero income and your carrying costs.  And filing a business for several years with no income might cause the IRS to come back to you and tell you it was a hobby and to do it over.

 

 

----------

In fact, as I review this, your entire $100 cost might be taxable at this point.  We haven't discussed amortization or depreciation; in business, you normally have to depreciate assets over their useful life, and this includes intangible assets, which includes trademarks and domain names. 

 

Consider the following scenario.  (I assume the useful life to be 5 years on average.)

 

Bought in 2015 for $10, deducted $1 for depreciation on schedule C, your cost basis is now $9.

Paid $10 fee in 2016, deducted the $10 fee as a business expense and deducted $2 for depreciation on schedule C, your cost basis is now $7.

Paid $10 fee in 2017, deducted the $10 fee as a business expense and deducted $2 for depreciation on schedule C, your cost basis is now $5.

Paid $10 fee in 2018, did not file schedule C, did not elect to capitalize. 

Paid $10 fee in 2019, did not file schedule C, did not elect to capitalize. 

Sold for $100 in 2020.  Since your cost basis is $5, you have a $95 capital gain.  $5 is taxed as depreciation recapture at your ordinary income tax rate (capped at 25%) and the other $90 is taxed as a long-term capital gain.

 

You have to pay depreciation recapture on depreciation you took or could have taken even if you didn't take it. There is a way to fix the problem of not taking depreciation but it requires an accountant.

 

----------

Overall, you may want to pay for professional advice if the amount is substantial.  If the amounts are small, I would assume that you need to pay capital gains tax on the difference between your selling price and the cost basis, and you lose any deduction or adjustment for carrying costs.  If you deducted the purchase price as a business expense on schedule C, then your cost basis is zero and you pay capital gains tax on the entire amount, and call it a learning experience. 

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*
evil_shenanigans
Level 3

Trading domain names - business or investment?

Wow! Lot to discuss here. But I'm a little confused where depreciation comes into it. Up to now I have filed a Schedule C for this activity. I've managed these domains as *inventory*, not as assets, as they were always intended for resale. However, if that's the case, I think there's no consideration of depreciation *or* capital gain, right? I would just be paying income tax on the sales price and deducting cost of goods sold in the standard way for inventory (i.e., how I've done it until now).

 

Conversely, if I consider these investments, not business assets or inventory, is there any depreciation to worry about? I thought the only consideration in that case would be figuring out the cost basis (i.e., whether or not I can recapture some of the registration costs).

Opus 17
Level 15

Trading domain names - business or investment?


@evil_shenanigans wrote:

Wow! Lot to discuss here. But I'm a little confused where depreciation comes into it. Up to now I have filed a Schedule C for this activity. I've managed these domains as *inventory*, not as assets, as they were always intended for resale. However, if that's the case, I think there's no consideration of depreciation *or* capital gain, right? I would just be paying income tax on the sales price and deducting cost of goods sold in the standard way for inventory (i.e., how I've done it until now).

 

Conversely, if I consider these investments, not business assets or inventory, is there any depreciation to worry about? I thought the only consideration in that case would be figuring out the cost basis (i.e., whether or not I can recapture some of the registration costs).


We're starting to get out of my comfort zone at this point.  The domain name is certainly an intellectual property asset to the company that buys it to use in business.  It may be inventory to you, I'm not sure.  But that would mean first of all, that you have already deducted the cost as a schedule C business expense when you brought them, so when you sell them now the entire amount is taxable income, because your cost basis is zero.  Second, it would mean that there is no way to capitalize your carrying costs (even if it were allowed after tax reform) because it's not a capital asset.  There are separate rules for what happens when you close a business and have leftover inventory to dispose of.  Here's one answer.

https://ttlc.intuit.com/community/business-taxes/discussion/i-need-to-know-how-to-handle-inventory-a...

 

Here's another answer.

https://ttlc.intuit.com/community/business-taxes/discussion/we-are-closing-our-retail-business-and-w...

 

Did you ever close out your schedule C buisness?  If not, then this inventory is still schedule C inventory, and you can't covert it to personal use without closing the business, either by filing an amended tax return for the last year the business operated, or by closing it this year. 

 

You also say "up to now I've filed a schedule C" so the question still is, when did you stop being a business?  Maybe you should keep listing it as a schedule C business even if your activity is low key.  That way you can deduct the annual renewals as schedule C expenses instead of worrying about whether or not they could have been capitalized.  The selling price is gross income, and you pay income tax and SE tax on the net profit.

 

If you close the business and convert the inventory to personal use, and you use the "reduce COGS method" on your last schedule C, then when you convert the inventory to personal use it has its original cost basis for you.  When you then sell the domains as hobby income, your taxable gain is the difference between the selling price and the cost basis.  It is still either a long term or short term capital gain, but the holding period for the capital gains calculation only starts as of the date you convert the inventory to personal use, not the date of the original purchase.  And you would not have any way of recovering your carrying costs if you continue to hang on to them.  

 

(Consider the example of a retailer who closes the business, puts everything in a storage locker, and sells their last few items as a hobby.  After the 2018 tax reform law, there is no method to deduct the cost of the storage locker from the hobby income.  You would be in the same position.)

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*
evil_shenanigans
Level 3

Trading domain names - business or investment?

Certainly it would be easiest for me to just continue to treat the domain trading as a Schedule C business as I've done for years now. The only relevant question for me is whether it's appropriate/legal to treat it that way: i.e.  should they always have been personal property (Schedule D investments)? Or should I have converted them to personal property at the end of the first year when I gave up actively pursuing this business?

 

It's definitely not worth my time to try and figure out how to maximize my deductions or anything; the simplest legal/appropriate method of handling this is what I'm going for here.

 

It seems like my options are these:

  1. Continue to treat this as a Schedule C business as always (with the domains as inventory).
  2. Close the business, converting the domains to personal use ("purchases withdrawn for personal use"), and paying Schedule D capital gains on the cost basis for any future sales.
  3. Simply ignore previous years, treating the domains as Schedule D personal property from now on, and paying Schedule D capital gains on the cost basis for any future sales. (Optionally, amend all the previous returns, though frankly I don't see myself getting around to that.)

 

What do you think? I'm not sure if there's a net difference in taxes I owe between options 2 and 3 or merely a recordkeeping discrepancy.

Opus 17
Level 15

Trading domain names - business or investment?


@evil_shenanigans wrote:

Certainly it would be easiest for me to just continue to treat the domain trading as a Schedule C business as I've done for years now. The only relevant question for me is whether it's appropriate/legal to treat it that way: i.e.  should they always have been personal property (Schedule D investments)? Or should I have converted them to personal property at the end of the first year when I gave up actively pursuing this business?

 

It's definitely not worth my time to try and figure out how to maximize my deductions or anything; the simplest legal/appropriate method of handling this is what I'm going for here.

 

It seems like my options are these:

  1. Continue to treat this as a Schedule C business as always (with the domains as inventory).
  2. Close the business, converting the domains to personal use ("purchases withdrawn for personal use"), and paying Schedule D capital gains on the cost basis for any future sales.
  3. Simply ignore previous years, treating the domains as Schedule D personal property from now on, and paying Schedule D capital gains on the cost basis for any future sales. (Optionally, amend all the previous returns, though frankly I don't see myself getting around to that.)

 

What do you think? I'm not sure if there's a net difference in taxes I owe between options 2 and 3 or merely a recordkeeping discrepancy.


I think you can probably keep your inventory as a business inventory even if you stopped pursuing the business briefly, assuming you reasonably plan to return to business.  So I think you can still file a schedule C this year even if you skipped it for a couple of years.  (Again, consider the owner of a toy shop who closes the store due to illness and packs the inventory into storage, then a few years later, resumes business activity by selling the items online in a virtual store.  The items were never really converted to personal use.)

 

The difference between #1 and #2 is that, as a business, you can deduct your ongoing maintenance and carrying costs, such as annual renewals, but you pay income tax AND self-employment tax.  As a hobby, you need to properly close down the business including converting the items to personal use.  (You could do that in 2020 or by amending 2019.  Ideally you would do it in a year when you had at least some income to cover the COGS adjustment on the inventory converted to personal use.)  You will eventually pay less tax as a hobby (once the holding period for the domains is more than 1 year) but you can't deduct carrying costs.

 

It's hard to say which is better, I guess it depends on what your carrying costs will be as a percentage of eventual selling prices.  The higher the carrying costs, the better option #1 becomes.

 

I don't like #3 just because I prefer to follow the rules.  Even with #3, we have to assume your cost basis in the assets is zero, since the price was deducted as COGS when you bought them.

 

Frankly, this all sounds like a monkey trap--there is a jar with a banana in it; if the monkey grabs the banana, his fist is too big to get his hand out of the jar, but if he lets go of the banana to take his hand out of the jar, he loses the banana.

 

You own these domain names that you paid for, that you keep paying for, and that you believe will someday sell for more than your total investment, but you aren't really interested in actively marketing them and want to wait for customers to find you.  If you let them expire, you lose your sunk costs, but if you keep them, your costs keep going up, and your return on investment is always "maybe some day."  Do you really need the tax hassle on top of that?  Maybe it is time to just let them drop and do something else. 

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*
evil_shenanigans
Level 3

Trading domain names - business or investment?

Thanks @Opus 17 - I think you are right! Not worth the hassle. But, to clarify -- if I just "drop them", is that essentially converting them to personal use? I think I'd still have to go through that step first, right?

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