Developer to Investor: The Benefits
Anita S. Wescott
A builder or developer who sells properties in the “ordinary course of business” is considered a dealer and the properties are considered inventory. Inventory sold in the ordinary course of business gives rise to ordinary income. In today’s real estate environment, it is not hard to imagine a scenario in which a builder or developer may be unable to sell or lease a building he has constructed.
If due to unforeseen circumstances, a developer or builder is unable to sell a piece of property, there is merit in considering whether the individual traditionally considered a dealer has become an investor in a rental property.
This change in status from dealer to an investor could result in several beneficial tax consequences.
- An investor does not pay self-employment tax on the net income produced from rental properties
- Rental properties can be depreciated. The depreciation can be used to offset rental income. Even if the property is vacant, depreciation can be deducted as long as the property is placed in service and reasonable attempts to rent the property have been made.
- Placing the property in service also stops the “production period” for a newly constructed building. Soft costs like real estate taxes and interest can be deducted rather than capitalized.
- Gain from the sale of rental real estate is capital gain. If the property is held for more than a year, the gain will be taxed at preferential long-term capital gain rates.
- If the property is sold at a loss, the loss is still ordinary.
- In most circumstances, capital gain property can receive installment sale treatment – a potential selling tool.
- Property held for investment may be eligible for Sec 1031 exchange transactions – a potential way to sell the property.
- Be aware of passive activity rules when calculating potential tax benefits.
- What about status as a real estate professional?
Each set of facts and circumstances must be analyzed independently to determine whether a change in status can be supported by the IRS. The Tax Court has held that a taxpayer can be both a dealer and an investor at the same time for different properties.
Each case must be decided on its own facts. The following are factors to consider:
- The reason, purpose or intent for which the property was acquired.
- The frequency, continuity, size and nature of the transactions supporting the trade or business.
- The activity to improve or dispose of the property.
- The extent of improvements made to the property.
- Timing of the purchase and sale.
- The taxpayer’s business.
- Advertising to promote sales.
- Listing the property for sale with a sales broker.
Consider the following to support investment intent:
- Do not hold the property in an operating entity such as a construction business.
- Keep separate books and records for the new rental activity.
- Do not list the property for sale. Consider holding for more than a year to receive long-term capital gain treatment.
- Consider using a tenant real estate agent to find a tenant.
Under the right circumstances, being treated as an investor rather than as a dealer for a given property may have advantages. An appropriate analysis is necessary, and documentation and good recordkeeping are essential to support the position.