Are You a Real Estate Dealer or Investor?
Among the many tax benefits available to real estate investors is the ability to pay a reduced tax rate on the gain from the sale of properties.
When a real estate investor sells a property, the investor pays capital gain rates. The maximum long-term capital gain rate is 20% for properties held more than 12 months.
When a real estate dealer sells a property, the dealer pays their ordinary tax rate plus self-employment taxes. The maximum ordinary tax rate is 37% and self-employment taxes are 15.3%. These taxes are assessed regardless of how long the dealer owned the property.
The disparity in the tax rates on the gain creates an obvious incentive to be classified as an investor and not as a dealer. Many people think they can simply hold a flip for 12 months and enjoy “investor” status… but it’s not that simple.
Let’s take a look at the factors the IRS and Tax Courts consider when deciding if someone is a real estate investor or dealer.
Who is a Dealer and Who is an Investor?
A real estate dealer is someone who buys and sells real estate through the ordinary course of their business.
Homebuilders, rehabbers, flippers, and developers are common examples of real estate dealers.
When a dealer buys and sells a property, the property is treated as inventory. Similar to the treatment of inventory, most of the labor, material and holding costs are added to the basis of the inventory and only deducted once the inventory is sold. The net gain is considered ordinary income.
On the other hand, a real estate investor purchases and holds real estate over a period of time for appreciation and cash-flow. When an investor buys real estate, the basis is depreciated each year. And when an investor sells real estate, they will realize a capital gain or loss on sale.
What Factors Make You a Real Estate Dealer?
Even though a taxpayer may be tagged as a real estate dealer, the factors discussed below are analyzed on a property-by-property basis.
As a result, it is possible for a real estate dealer to hold a property for investment purposes and still enjoy capital gain treatment.
In the below Tax Court case, the taxpayer was in the business of buying and selling real estate but was able to win over the Tax Court, on appeal.
The Tax Court properly determined that taxpayer was engaged in the business of acquiring and holding real estate both for investment and for sale in the ordinary course of its business. As held in our prior opinion, it is possible for a dealer in real estate to hold specific property for investment rather than for sale in the ordinary course of its business. . . .
Taxpayer’s initial contact with the Frisco property was its purchase of a 240 acre tract including this property at a tax sale, about 1940. The present tract consists of 87.3 acres which adjoins the Frisco railroad for one and one-half miles. By February 10, 1947, taxpayer had perfected title to this land by obtaining a warranty deed from the former owner. Its over-all cost for the Frisco tract was approximately $80 an acre. . . .
Frisco, on its own motion, opened negotiations for control of the land. Sale of the land to Frisco was discussed as well as leasing. This culminated in 1953 in a ten-year lease of the property to Frisco at $100 per acre per year rental, with option to renew for eighty-nine years. Taxpayer’s testimony is that it wanted Frisco to have an investment in the property which would encourage it to exercise the option to extend the lease and that this was accomplished by Frisco agreeing to buy five acres at $4000 an acre. The lease also gave Frisco the option of buying additional land for $4000 per acre. . . .
The first sale to Frisco occurred some six years after taxpayer had perfected title to the property and some twelve years after the tax sale purchase. . . . Taxpayer’s efforts to advertise or offer the property for sale were minimal. The fact that taxpayer was ultimately able to obtain an extremely favorable long term lease upon the property is corroborative of its intent to acquire and hold the property for investment.
Municipal Bond Corporation v. Commissioner, 382 F.2d 184, 188 (8th Cir. 1967)
To determine if a property qualifies for capital gain treatment, or is subject to ordinary income + self-employment taxes, we must determine whether the property was primarily held out for sale to customers in the ordinary course of the dealer’s trade or business.
There are three main factors that, if all are met, will result in ordinary income treatment:
- The taxpayer is engaged in a trade or business.
- The taxpayer is holding the property primarily for sale in that trade or business.
- The sale of the property is ordinary for that business.
“Primarily for sale” is further broken down into nine additional factors.
While no one factor is controlling, the Courts have placed the most emphasis on the following factors in order of priority: (1) factors 4 and 5; (2) factors 1, 2, and 9; and (3) factor 3.
- The purpose for which the property was initially acquired.
- The purpose for which the property was subsequently held.
- The extent of improvements the taxpayer made to the property.
- The frequency, number, and continuity of sales.
- The extent and substantiality of the disposition of the property.
- The extent and nature of the taxpayer’s business.
- The extent of advertising, promotion, or other active efforts used in soliciting buyers for the sale of the property.
- The listing of the property for sale through a broker.
- The purpose for which the property was held at the time of disposition.
Frequency, Number, and Continuity of Sales
Many investors think that if they flip just one property per year, they don’t need to worry about dealer status.
However, in Suburban Realty Co. v. United States, the taxpayer lost that argument.
The general rule derived from Tax Court cases is that if you are buying and selling homes over several years and the profits are a substantial portion of your income, then the property sales will trip factors #4 and 5 above. This means the profits from the sales will be subject to ordinary income and self-employment taxes.
If, however, you just flip one deal and don’t plan to continue, it’s unlikely that you’ll trip factors #4 and 5. Assuming you don’t also trip the other factors with your facts and circumstances, the profit from this one flip could be considered “capital” meaning you’d pay long or short-term capital gain taxes as opposed to ordinary income and self-employment taxes.
The Purpose for Which the Property Was Acquired and Held
As mentioned above, factors #1 and 2 are weighted second, behind factors #4 and 5.
Factors #1 and 2 are all about intent.
Many real estate investors attend conferences and networking groups and hear that they need to write down a statement of intent and the deal will qualify for capital gain treatment.
We wish it were that simple, but here’s a quote from a Tax Court case:
In deciding the holding purpose issue, more weight is given to objective evidence than to the taxpayer’s own statements of intent.
Guardian Industries Corp. v Commissioner, 97 T.C. 308 (1991)
What objective and factual activities and documents show a taxpayer’s intent?
- Advertising activities
- Subdividing and selling individual lots
- Making improvements consistent with intention to sell
- Making improvements consistent with intention to hold
- Whether or not the property was rented
- How long the property was held and how much development activity was conducted
- How the taxpayer records the property on their books (i.e. Inventory vs. Rental Property)
- Corporate minutes at acquisition vs. sale
- Notes of partnership meetings
- Other contemporaneous documents demonstrating a taxpayer’s change in intent
While writing a statement of intent and renting a property can certainly help your case to avoid dealer status, your case could be blown up by other activities that indicate your true intent, such as your efforts at advertising the property for sale.
How to Avoid Dealer Status
Avoiding dealer status is all about controlling your facts.
Remember that dealer status is assessed on a property-by-property basis. So even if you are a flipper, builder, developer, etc., you can still own investment property that may avoid dealer status.
Think about factors that demonstrate investment intent.
Such factors could be holding the property for a long time for appreciation purposes, renting it out, not engaging in substantial improvements during the hold period, claiming depreciation and reporting the rental as a capital asset on your books, and not advertising the property for sale until the very end of the “long” hold period.
You can also avoid flipping multiple properties over multiple years (avoids tripping factor #4) and build a non-real estate income stream so that the profits from the flips are not substantial in comparison (avoids tripping factor #5).
Some advisors advocate that you can just report the flips on Schedule E and/or Schedule D. They reason that if you report on Schedule C you are blatantly admitting that you are a real estate dealer.
Be cautious engaging these practitioners. If that’s their solution to avoid dealer status, they don’t fully understand the concept and are exposing you to significant risk (audit + back taxes + interest + penalties).
The best way to avoid dealer status?
Don’t flip homes and lots.
But where’s the fun in that…
Takeaways
Being classified as a real estate dealer will ensure that gains from the sale of your real estate properties is taxed at ordinary income + self-employment tax rates.
Conversely, real estate investors pay preferential capital gain taxes on the gains from the sale of their real estate properties.
You are a dealer if you are (1) engaged in a trade or business; (2) holding the property primarily for sale in that trade or business; and (2) the sale of the property is ordinary for that business.
Whether or not the property is held primarily for sale depends on assessing your situation against nine factors developed by the Tax Court over time. No one factor is controlling, but factors #4 and 5 carry the most weight.
Avoiding dealer status is more intensive than simply not reporting your activities on Schedule C. Be wary of advisors that think that solves your problems.
