Tax law is forever classifying people and making structures that either create benefits or disadvantages on your tax return. Part of getting the most from your return is about understanding the definitions of the IRS. Two that seem very similar, but have distinctly different consequences on your taxes, are real estate dealer and real estate investor.
What’s the Downside of Each?
We’ll start by discussing the disadvantages. That’s right—there is no golden choice when trying to figure out if you classify as a dealer or an investor. In either case, there will be some disadvantages.
As a real estate dealer:
- Your profits are taxed at both the ordinary income rates (up to 35 percent) AND the self-employment rates (up to 14.13 percent).
- You may not depreciate property that you are holding with the intention of selling.
- You may not use the tax-favored installment method to report dispositions of your property.
- And, you may not use the Section 1031 exchange to defer taxes on properties you hold as a dealer.
As a real estate investor:
- You are subject to the net capital losses limit of $3,000 (applied after gains are offset against losses).
- You must treat selling expenses as a reduction in sales proceeds, which means those expenses produce benefits at the capital-gains tax rates only.
Admittedly, the dealer gets the lesser deal when it comes to disadvantages. The investor does get to depreciate property, is allowed to sell using the tax-favored installment method, and may choose to use a Section 1031 exchange, thereby deferring taxes on a disposition.
What about the Up Side?
Every coin has a heads and a tails. And, it’s the same with tax designations. Both dealers and investors gain some advantages from their respective positions.
Advantages for real estate dealers include:
- You are treated as a business and may treat most expenses as ordinary business deductions (advertising, commissions, legal fees, real estate sales, etc.).
- Your property sale losses are not limited capital loss cap of $3,000 that limits investor properties.
- Your losses are deducted as ordinary losses.
- You get to deduct the entire loss (either immediately or using the net operating loss rules to deduct it over time—these rules allow you to carry back your losses up to five years and forward up to twenty years).
Advantages for real estate investors include:
- Your sales profits are taxed at 15 percent or less, a tax-favored capital gains rate.
- You are not subject to the self-employment tax.
So, what does all this mean for you and your business? Let’s run through some example numbers. For the example, we’ll say you have a $90,000 profit from a property sale. Based on the tax rates mentioned above, your taxes as a dealer could be as high as $36,370. Your taxes as an investor might be as high as $13, 500.
You can clearly see that having your properties qualify as investment sales generates a considerable tax savings—potentially $22,870!
However, depending upon your business structure and activities, it may not be possible to define all of your property sales as investment sales. No problem. The IRS has no qualms with an individual taxpayer acting as part dealer and part investor. You read that right; you can balance the pros and cons of each situation. It’s simply a matter of taking each property on a case-by-case basis.
Not so fast. You may think the IRS is giving you some kind of free gift by allowing this pick and choose method, but it’s not quite as unstructured as all that. You will be required to make a clear distinction in your record books. You didn’t think the IRS was going to let you off without documentation, did you? And, this means you must decide before-hand which route you’re going with each property sale. You cannot simply go back over your sales at tax time and assign designations. You will have to establish what your intent was with the sale—dealer sale or investment sale.
Tips on Documentation
Good documentation of your purpose and activities helps you to establish your case with the IRS. You should determine, and make note of, your intent for the property throughout the process:
- When you purchase the property;
- During your ownership; and
- At the time you sell it.
If you keep records throughout the process (not just at the time of sale) it gives your case credibility. It’s important to keep in mind, however, that if your return is challenged in court, they will likely examine the sale when they rule on whether you acted as a real estate dealer or real estate investor on a particular property. None of this means that your purpose may not change between the time you buy a property and sell it, but at least you will be prepared to understand and plan for such a scenario.
The All Important Point-of-Sale
Important: The point-of-sale is the most critical part of the process in determining your investor or dealer status. It’s often the deciding factor in IRS decisions. Although a single piece of real estate can have features of both dealer and investor property, it can only be treated as one or the other. Take a look at the characteristics of each from a tax standpoint.
- Real Estate Dealer—First off, dealer property is held with the intention of being to customers in the ordinary fashion of business or trade. If you buy and sell many properties throughout the year, you are likely a dealer regarding those properties. Unfortunately, the IRS has not established any set number for determining dealer status, so it’s all about making your case. In fact, number is only one factor, and in previous rulings:
- A company earned dealer status with only one sale because it had already agreed on sale to a third party prior to purchasing the property itself;
- A taxpayer, Mr. Goldberg, did not earn dealer status even with 90 home sales in a year. In his case, the homes were built for rentals and used as such prior to the time of sale.
However, in the majority of cases, more sales equal dealer properties. In addition to the influence of the number of properties sold, real estate that you subdivide also has an increased chance of achieving dealer status, except under Section 1237. Removing a lien can also make a property more salable under the ordinary processes of business (recall that dealer property is sold in the ordinary course of business).
Several other traits indicate a dealer business transaction over investment actions. They include active marketing and sales activities, property held for a short period of time (indicating the intention to turn over the property for profit), generally making your living as a dealer, regularly buying and selling real estate for your own account, and buying property with the proceeds from another property.
- Real Estate Investor—In contrast to dealer property, investor property is held with the intention of producing rental income or appreciating in value. This means that investor properties are typically held for longer periods of time and are not often sold, unlike the quick turnover of a dealer property. Other situations in which a court may rule your property is an investor property include acquiring the real estate by inheritance, dissolution of a trust, or a mortgage foreclosure. It’s even possible for you to make improvements to such property prior to selling it and still retain investor status.  Just don’t put the proceeds into more real estate or subdivide the property if you want to maintain that status.
If you don’t make clear in your documentation which type of property sale you are making, the IRS will make the decision based on their interpretation, and that is not the best situation for you! So, look at those characteristics above again. Since you’re going to know at the outset what your purpose is with each property, you can make sure to include as many of the appropriate features as possible well before the sale.
- The usual self-employment tax rate times the Schedule SE adjustment. ↑
- Assuming the real estate profits were your only income. ↑
- Tollis v Commr., T.C. Memo 1993-63. ↑
- Sanders v U.S., 740 F2d 886. ↑
- IRC Section 1221(a)(1). ↑
- Sanders v U.S., 740 F2d 886; Suburban Realty Co. v U.S., 615 F2d 171. ↑
- S & H, Inc., v Commr., 78 T.C. 234. ↑
- S & H, Inc., v Commr., 78 T.C. 234. ↑
- Revenue Ruling 57-565 ↑
- IRC Section 1237. ↑
- Miller v Commr., T.C. Memo 1962-198. ↑
- Hancock v Commr., T.C. Memo 1999-336. ↑
- Stanley, Inc. v Schuster, aff’d per curiam 421 F2d 1360, 70-1 USTC paragraph 9276 (6th Cir.), cert den 400 US 822 (1970); 295 F. Supp. 812 (S.D. Ohio 1969). ↑
- Suburban Realty Co. v U.S., 615 F2d 171. ↑
- Armstrong v Commr., 41 T.C.M. 524, T.C. Memo 1980-548. ↑
- Mathews v Commr., 315 F2d 101. ↑
- Planned Communities, Inc., v Commr., 41 T.C.M. 552. ↑
- Nash v Commr., 60 T.C. 503, acq. 1974-2 CB 3. ↑
- Rymer v Commr., T.C. Memo 1986-534. ↑
- Estate of Mundy v Commr., 36 T.C. 703. ↑
- U.S. v Rosbrook, 318 F2d 316, 63-2 USTC paragraph 9500 (9th Cir. 1963). ↑
- Cebrian v U.S., 181 F Supp 412, 420 (Ct Cl 1960). ↑
- Yunker v Commr., 256 F2d 130, 1 AFTR2d 1559 (6th Cir. 1958). ↑
- Metz v Commr., 14 T.C.M. 1166. ↑
- U.S. v Winthrop, 417 F2d 905, 69-2 USTC paragraph 9686 (5th Cir. 1969). ↑