As someone who deals with real estate transactions on a regular basis, you may wonder why it is necessary to distinguish between being an “investor” as opposed to a “dealer” for tax purposes. But that distinction is very important to the IRS and how your real estate profits can impact your tax bill.
Making It an Investment
Real estate investors enjoy several tax advantages that are not available to real estate dealers. Perhaps the simplest tax rule is that an investor’s gain on sales of real property held long term (more than one year) are subject to tax at capital gains tax rates. Investors can also choose to reinvest the proceeds of real estate investments and engage in tax-free Section 1031 (like-kind) exchanges or create installment sale transactions that allow for the deferral of income taxes.
Real estate dealers face higher tax rates in many instances. Under Internal Revenue Code Section 1221, real property held for sale to customers in the ordinary course of a regular trade or business — including property held by a dealer — is not a capital asset. Dealers must treat gains as ordinary income, which is taxable at a substantially higher rate (up to 39.6%) than long-term capital gains (either 15% or 20% for higher-income taxpayers), with possibly higher rates if some of the gain from prior depreciation is recaptured.
In addition, many dealers have combined their real estate activities with the rest of their business, which means that the dealer’s ordinary income (including gain on the sale) will also be subject to self-employment tax (up to a 15.3% tax rate). Investors are not required to pay self-employment tax on their gains, but they may have to pay a 3.8% Medicare tax on some or all of their gains.
One limited tax benefit for dealers is their losses are considered “ordinary” losses, so they are not subject to restrictions on deducting capital losses. An ordinary loss may be used to offset both capital gains and ordinary income to reduce tax liability. Dealers also are allowed to deduct their entire interest expense on property from ordinary income, while investors cannot claim interest expense deductions greater than the amount of their net investment income.
Understanding the Difference
So how do the IRS and the courts distinguish between an investor and a dealer for tax purposes? There is no all-inclusive list of criteria. Based on various court decisions, relevant factors include the taxpayer’s sources and amounts of income, along with the value, volume and frequency of the real estate transactions. Generally, investors purchase properties and hold them with a long-term intent, while dealers buy and sell properties relatively quickly. This means that how many properties and for how long the taxpayer has owned them is critical. For example, if you hold a single property for more than a year, the IRS is likely to treat you as an investor. If you hold multiple properties for less than a year, the tax treatment is more likely to be designated as a dealer. Courts also look at the nature and purpose for which the taxpayer acquired, held, and sold the property, as well as the nature and extent of the efforts to sell the property. The extent of subdivision, development, and improvements made to the property to increase sales will also be evaluated.
A court might weigh whether a business office and brokers are used to sell property, the character and degree of control by the taxpayer over the agents who sells the property and the extent of advertising the property. Courts may consider whether the taxpayer has experienced a “change of plans” — such as a rental or relocation plan — that modified the original intent or use of the property. Also, the taxpayer may be held to the same tax status it held itself out to the public.
Due to the facts-and-circumstances nature of these criteria, you need to maintain appropriate documentation to evidence your activities, plans and intentions. No single factor or combination of factors will entirely settle the issue. You could even qualify as an investor for one property and a dealer for others, depending on how you structure and manage each of your transactions.
Create a Safety Net
You do not have to swim through the murky waters of determining whether you are an investor or a dealer by yourself. For help determining not only which category applies to you and each property you currently own, but also which one would work better for you, contact Tom Kosinski at [email protected] or call him at 312.670.7444. If appropriate, you may need to change your plans to manage your tax status in advance of a sale. Some proactive tax planning can avoid surprises after you have reaped the reward of your profit.