The Real Estate Dealer Status
by Alex Everest February 7, 2011
The real estate dealer status is
an IRS classification which determines how the income an investor receives from
his real estate holdings will be taxed. The IRS very generally defines a real
estate dealer in the following way:
IRS Publication 334: Tax Guide for Small Business
Real Estate Dealer - You are a real estate dealer if you are engaged in the business of selling real estate to customers with the purpose of making a profit from those sales.
This definition leaves room for interpretation and creates a lot of gray area. In fact, it is a highly lease/option or contract for deed (aka land contract or installment sale). The gains from these "sales" obviously occur over many years, sometimes 20-30 years. Oftentimes, the "paper profits" from these deals never materialize at all. As a result, the tax consequences for these types of sales is important.
The dealer status is notoriously subjective and will depend on a number of factors. It may ultimately depend on a tax court's view of the investor's particular situation. So, while there is no definitive test for determining whether an investor is a dealer, you should understand that the IRS will weigh the following factors:
*Purpose of the acquisition
*Length of ownership
*Number of transactions by investor
*Proportion of income from real estate sales
*Frequency of sales
*Amount of gain realized
*Nature of advertising for the properties
If an investor is pegged as a dealer, then ALL of the investor’s real estate related profits may be treated as ordinary income and may also be subject to self-employment tax. This applies even in situations when the investor’s true intent is to keep a particular property as a long-term investment. As a result, the investor will lose the benefits of depreciation and long-term capital gains tax treatment. This is the case even if you collect your profit over 20 or 30 years! If that’s not enough, when you get pegged as a dealer you also lose the ability to do 1031 exchanges.
There are a number of situations in which the dealer status may affect you as a real estate investor. The following scenarios illustrate a few ways in which you may be affected. However, note that these scenarios also assume the investors have NOT formed any entities in which they do business. In other words, they are simply doing business in their own name. This is an important point which we will discuss later.
Scenario #1: You’re a flipper (wholesaler or a rehabber).
If you flip properties for short-term income, then the IRS will classify you as a real estate dealer. Your properties will be treated as inventory and you will report your profits on Schedule C of your federal income tax return. The gains will also be subject to self-employment tax.
Scenario #2: You’re primarily a landlord, but you occasionally do flips for additional income.
If you buy and hold properties for long-term appreciation, then you are normally considered an investor by the IRS. However, if you start to dabble in a few flips to generate income, then the IRS may peg you as a real estate dealer. Thus, ALL of your real estate income may be subjected to dealer tax treatment. Your rental income may be treated as ordinary income and be subject to self-employment tax. In other words, you may lose your ability to have income from these properties taxed using long-term capital gains rates.
Scenario #3: You sell most of your properties on land contract or lease/options, but you also occasionally do few flips for additional income.
If you sell properties using owner financing or lease/ options, then you likely use the installment method to report your gains.
However, since you do a few flips
on the side, the IRS may classify you as a dealer and tax all of your
properties as such. Instead of getting taxed over 20-30 years on your
"potential profits" from these sales and as you receive them, you
will get taxed upfront on all your paper profits, even if you never
actually realize those gains!
Scenario #4: You’re primarily a flipper, but you also have a few rentals on the side.
If you flip most of your properties, then the IRS will classify you as a dealer and may tax all of your properties, including your rental income, as such.
As you can see, there are many situations in which investors may cross the lines into a gray area, resulting in potentially huge sums in unexpected taxes, interest, and penalties.
How do savvy investors manage this burdensome tax classification? The answer is to operate your different real estate activities through separate entities, such as corporations or LLCs.
In other words, one entity for active investing (wholesale flips and rehab flips) and another entity for passive investing (rentals, owner financing, and lease options).
The separation of activities subjects only your active investing corporation to ordinary income tax treatment, while your passive investing corporation still enjoys the benefits of depreciation, long-term capital gains treatment, and installment sales treatment.
Alex Everest, Founder and President of Deal Maker Library (http://www.dealmakerlibrary.com), is a nationally known real estate investor, author, speaker, and advisor from Minneapolis, Minnesota. He specializes in the areas of wholesaling, rehabbing, owner financing, and land trusts for residential real estate. Reprinted by Permission. Copyright © 2004-2014 BiggerPockets Inc. All Rights Reserved.