Being classified as a Real Estate Dealer, is potentially a huge tax trap for the unwary. It's a vague and complicated area of the tax code.
Here's the short explanation (yikes!):
Simply put: Dealer property is held for sale in the ordinary course of business - it's taxed in a manner similar to business inventory, without some of the special tax advantages that can be applied to business inventory..
Being considered a dealer means that a taxpayer is conducting a trade or business, not investing. It's not just semantics. A trade or business activity is taxed much differently than an investing activity (especially when it comes to real estate).
What’s wrong with being a dealer? You’ll pay higher taxes and have fewer tax planning opportunities. As a dealer, your earnings are subject to 15.3% self-employment taxes (which an investor does not pay). Your earnings are also subject to higher “ordinary income” tax rates, meaning you cannot obtain preferential long-term capital gain tax rates no matter how long you hold the property. The property cannot be exchanged in a like-kind 1031 exchange. And you cannot obtain the preferential treatment for selling investment property on an installment basis.
The classification of an investor as a dealer has been traditionally subject to interpretation of vague laws.
The courts have typically looked to a number of factors in deciding whether someone is an investor or a dealer. Here are 10 of the most important factors:
1). Taxpayer’s purpose for acquiring, holding and selling the property:
- Did the taxpayer the property for the purpose of holding it and renting it? Or did the taxpayer buy a property with the intent to subdivide and develop it?
2). Number, frequency and continuity of sales:
- The more frequently a taxpayer sells property, the more likely a court will determine that the taxpayer is a dealer. Of all the factors, this probably is the most important one.
3). Duration of ownership:
- The shorter the time of ownership, the more likely that the IRS and courts will determine dealer status.
4). Time and effort expended by the taxpayer in promoting sales of property:
- The more time and effort devoted to sales, the more likely the taxpayer is a dealer and not an investor.
5). Improvements and subdivision:
- Substantial improvements and/or subdivision is indicative of a dealer and not an investor.
6). Ordinary business of the taxpayer:
- A taxpayer whose only business activity is buying and selling properties is more likely to be declared a dealer than, say a surgeon who owns several apartment buildings and occasionally buys and sells rental properties.
7). Extent of taxpayer’s real estate holdings:
- A taxpayer whose real estate holdings are incidental to other investment activity, is less likely to be considered a dealer than a taxpayer who only holds real estate as an asset.
8). Income from real estate activities, as compared to income from other activities:
- If income from real estate activities is incidental to other income, the taxpayer is less likely to be considered a dealer.
9). Amount of advertising and sale efforts:
- A dealer is more likely to utilize advertising and sales efforts than an investor. Sales offices are often utilized by dealers.
10). Taxpayer control over sales representatives:
- Business owners (dealers) are more likely than investors to exert direct control over their sales representatives. Investors, on the other hand, are more likely to utilize the services of independent sales brokers and agents.
Primary purpose: Section 1221 of the tax code uses the word “primarily.” This means that if a taxpayer has multiple purposes for owning a property, and the secondary purpose is to make dealer profits, the property would not be considered dealer property. That was the case in Malat v Riddell 383
US
569.
Whew! That was the short explanation. Complicated? You bet. But we can consult with you on how you structure your real estate investing activities in order to reduce the liklihood that the IRS will consider you a dealer, and not an investor.
