Investor vs. Dealer: The Difference is not Always Black or White
JEFF NEWMAN, CPA, JD
Knowing whether you are an investor or a dealer in the world of real estate is critical. Why? Because the way the IRS treats you could have a significant impact on your tax liability. There is a fine distinction between the two.
Vive la Différence!
Real estate investors enjoy several tax advantages that are not available to those deemed to be real estate dealers. Perhaps foremost, an investor’s gains on sales of property held long term (more than one year) are subject to tax at capital gains tax rates. Investors also may be able to engage in tax-free Section 1031 (like-kind) exchanges and installment sale transactions that allow for the deferral of taxes.
Dealers face steeper taxes in many instances. Under Internal Revenue Code Section 1221, real property held by a taxpayer for sale to customers in the ordinary course of a trade or business — that is, property held by a dealer — is not a capital asset. Dealers, therefore, must treat gains as ordinary income, which is taxed at substantially higher rates than long-term capital gains.
In addition, unless a dealer has set up a separate entity to reduce taxes, the dealer’s ordinary income (including gain on the sale) will also be subject to self-employment tax.
On the plus side for dealers, their losses are considered “ordinary” losses, so they are not subject to restrictions that limit the amount of capital losses a taxpayer can offset against ordinary income to reduce tax liability. Moreover, if the dealer materially participates, he will not be subject to the passive loss rules as an investor would be. Dealers also are allowed to deduct their full interest expense on property from ordinary income. Investors cannot claim an interest expense deduction greater than the amount of their net investment income. And, dealers can offer “rent-to-own” lease programs, in lieu of installment sales, to defer recognizing gains.
No Definitive Criteria
So how do the IRS and the courts distinguish between an investor and a dealer for tax purposes? There is no definitive list of criteria. The classification is based on all of the facts and circumstances. Based on various court decisions, though, relevant factors include the taxpayer’s sources and amounts of income, the value, volume and frequency of the taxpayer’s real estate transactions, and the taxpayer’s intent.
Generally, investors purchase properties and hold them with a long-term perspective. Dealers buy and sell properties relatively quickly. Therefore, how long the taxpayer has owned the property is critical. For example, if you hold a single property for more than a year, the IRS is likely to consider you an investor. If you hold multiple properties for less than a year, expect 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 taxpayer’s efforts to sell the property. Plus, the extent of subdivision, development and improvements made to the property to increase sales will 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 individual(s) who sells the property and the extent of advertising the property. Finally, the most important factor may be the frequency of sales. A dealer normally sells individual lots to individual buyers. However, if the landowner develops and subdivides a parcel and then sells the property in bulk to a builder, he may qualify for capital gain.
Last, courts will consider whether the taxpayer has experienced a “change of plans” — such as a divorce or relocation — that modified the original intent regarding the property. Also important is how the taxpayer holds itself out to the public (that is, as a dealer or as an investor).
Due to the facts-and-circumstances nature of these items, you need to maintain appropriate documentation to evidence your activities, plans and intent. No single factor or combination of factors will settle the issue. You could even qualify as an investor for one property and a dealer for others, depending on how you structure your transactions.
Bring in a Professional
It is critical that you contact your tax advisor before going into unknown territory regarding the investor vs. dealer quandary.
For help understanding the laws and securing the optimal tax treatment, or with questions, contact Jeff Newman at [email protected] or call him at 312.670.7444. Visit orba.com to learn more about our Real Estate Group.
Tax Court Disallows Property Owner’s Bad Debt Deduction
TAMARA PARTRIDGE, CPA
A real estate investor learned the hard way that he could not claim a deduction for business bad debt. In ruling that he couldn’t deduct about $153,000 in outstanding debt, the U.S. Tax Court in Langert v. Commissioner clearly explained the requirements that must be satisfied before a taxpayer can claim a business bad debt deduction.
Property Loan Goes Bad
The taxpayer had been involved for about 30 years in one or more activities involving real property, including buying, selling and renting real property, and providing management services. During that period, he made six loans, but he never advertised himself as a moneylender or kept a separate office or separate books and records relating to any of the loans.
Real Estate Professional Rules
“Passive activity” is defined as any trade or business in which the taxpayer does not materially participate. “Material participation” is defined as involvement in the operations of the activity that is regular, continuous and substantial. Rental real estate activities are generally considered passive regardless of whether you materially participate.
Internal Revenue Code Section 469 grants an exception from restrictions on PALs for taxpayers who are real estate professionals. If you qualify as a real estate professional and you materially participate, your rental activities are treated as a trade or business and you can offset any nonpassive income with your rental losses. You may also be able to avoid the NIIT as long as you are engaged in a trade or business with respect to the rental real estate activities (that is, the rental activity is not incidental to a nonrental trade or business).
To qualify as a real estate professional, you must satisfy two requirements: 1) More than 50% of the “personal services” you perform in trades or businesses are performed in real property trades or businesses in which you materially participate, and 2) you perform more than 750 hours of services in real property trades or businesses in which you materially participate.
The IRS Challenge
In Frank Aragona Trust v. Commissioner of Internal Revenue, the trustee had formed a trust in 1979, with his five children as beneficiaries. He died in 1981 and was succeeded as trustee by six trustees — the five kids and an independent trustee. Three of the kids worked full-time for a limited liability company (LLC), wholly owned by the trust, that managed most of the trust’s rental properties and employed about 20 other individuals.
During 2005 and 2006, the trust reported nonpassive losses from its rental properties, which it carried back as net operating losses to 2003 and 2004. The IRS determined that the trust’s real estate activities were passive activities, and the challenge landed in the Tax Court.
A Trust as a Real Estate Professional
The IRS contended that a trust could not qualify for the real estate professional exception because a trust cannot perform “personal services,” which regulations define as “any work performed by an individual in connection with a trade or business.” The Tax Court rejected this argument. It found that, if a trust’s trustees are individuals who work on a trade or business as part of their trustee duties, their work can be considered personal services that can satisfy the exception’s requirements.
Evaluating Material Participation
The IRS alternatively argued that, even if some trusts can qualify for the exception, the Aragona trust did not, because it did not materially participate in real property trades or businesses. The agency asserted that only the activities of the trustees can be considered, not those of the trust’s employees. And the IRS claimed the activities of the three trustees who worked for the LLC should be deemed activities of employees and not trustees.
The Tax Court did not decide whether the nontrustee employees’ activities should be disregarded in determining if the trust materially participated in its real estate operations. But it held that the activities of the trustee employees should be considered. It also noted that trustees are not relieved of their duties of loyalty to beneficiaries just because they conduct activities through a corporation that is wholly owned by the trust.
For technical reasons, the trust, in this case, was not required to prove that it satisfied the two-prong real estate professional test. Other trusts wishing to take advantage of the exception should be prepared to do so.
For questions, contact Tamara Partridge at 312.670.7444. Visit orba.com to learn more about our Real Estate Group.