Knowing whether you’re an investor or a dealer in the world of real estate is critical. Why? The way the IRS treats you could have a significant impact on your tax liability. The following Thomson Reuters content discusses the distinction between the two, and also includes additional perspectives from SC&H Group’s Tax Services team.
Real estate investors enjoy several tax advantages that aren’t 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 — isn’t 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 aren’t subject to restrictions that limit the amount of capital losses a taxpayer can offset against ordinary income to reduce tax liability. Dealers also are allowed to deduct their full interest expense on property from ordinary income; investors can’t 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.
Another factor to keep in mind is that ordinary income could be taxable to exempt investors, whereas capital gain income is generally not taxed to those investors. Exempt investors include public charities, labor unions, foundations, and qualified plan accounts – all of which are common investors in real estate projects. Further, ordinary versus capital gain income characterization can also be critical to foreign investors in U.S. real estate projects.
So, how do the IRS and the courts distinguish between an investor and a dealer for tax purposes?
There’s no definitive list of criteria. Based on various court decisions, though, relevant factors include the taxpayer’s sources and amounts of income and the value, volume, and frequency of the taxpayer’s real estate transactions.
Generally, investors purchase properties and hold them with a long-term perspective. Dealers buy and sell properties relatively quickly. So 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. The more properties held by the taxpayer, the greater the chance that dealer status is likely the correct answer.
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, theextent 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.
Last, courts will consider whether the taxpayer has experienced a “change of plans” — such as a divorce, zoning changes or rejections, 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). A recent case cited the taxpayer’s tax return which listed them as a dealer as evidence of their status.
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.
It’s critical that you contact your tax advisor before going into unknown territory regarding the investor vs. dealer quandary. Often, key planning steps can be undertaken when property is first acquired, or just prior to the beginning its development process, that can dramatically change the outcome for income tax purposes.
Please contact SC&H Group’s Tax Services team here if you have any questions about this information, or if you would like to discuss the distinction between investor vs. dealer in more detail.