The technicalities of whether you’re a real estate investor or dealer might not seem significant to you. But it matters a lot to the IRS. That’s why it’s important for you to know in which category your business falls, so you’re not caught off guard at tax time.
Real Estate Investor
Real estate investors purchase real estate with the intention of holding the properties and achieving a financial return. This classification would include someone who buys a house and rents it out to tenants over several years. An as a landlord, you would be able to deduct the hard operating costs of your properties—every ceiling or floor you repair, and each new plumbing fixture or electrical outlet your purchase. You also get deductions, such as depreciation, that are not related to actual operating expenses or repairs.
Real Estate Dealer
Real estate dealers are buying and selling real estate as their main business. This means that, like any other business, you are required to pay the self-employment tax of 15.3%. Unlike the investors, dealers are not buying properties with the intention of keeping them in their portfolio for the long term. If you’re flipping houses, that usually classifies you as a dealer. This classification also includes builders and contractors who construct houses and then sell them to end users.
Tax Rates Differ Greatly!
If you’re a real estate investor and you sell a property you’ve owned for more than a year, any gain you have is taxed at the federal capital gains tax rate of 15%. Depending you where you live or where your investment property is located, you may also owe capital gains at your state level as well.
If you’re a real estate dealer and you sell your properties, those properties are considered inventory and any gains are taxed at your ordinary income tax rate, which are considerably higher and might be as high as 35% for federal taxes.
The main factor in the IRS’ determination of whether you are a real estate investor or a real estate dealer is based on “intent.” What was your intention when you bought the property? As you can imagine, intent is a difficult thing to prove.
However, according to Diane Kennedy’s article on CRE Online, these are the top 15 things the courts will look at in determining your status:
- Your purpose for acquiring, holding and selling the property
- Number, frequency and continuity of sales
- Duration of ownership
- Time and effort you’ve expended in promoting sales
- Your use of brokers
- Extent of improvements and subdivision made to facilitate sales
- Your ordinary business
- Extent and value of the your real estate holdings
- Extent and nature of the transactions involved
- Amount of income from sales as compared with the your other sources of income
- Your desire to liquidate landholdings unexpectedly obtained
- Your overall reluctance to sell the property
- Amount of advertising you do
- Use of a business office for sales
- Your control over any sales representatives
On this list, the one most relevant issue seems to be the number, frequency, and continuity of sales. So if you sell a large number of properties, you could be considered a dealer based solely on perception. However, the classification of investor or dealer is applied on a property-by-property basis, so it’s also possible you could be deemed a dealer on one property and an investor on another.
Whether real estate is owned by an investor or a dealer and is a capital asset or an inventory item depends on all the circumstances of ownership, from the point of purchase through to the sale.
This is when the IRS will look at what your intent was regarding each specific property. They’ll look at your advertising activities, if you have a sales office and if you employ sales people. They’ll examine if the property is held in an individual’s name or were acquired in the name of an LLC or other entity. And they’ll look at how much of your income is coming from the sale of each property.
Knowing these factors will help you avoid a nasty surprise on tax day.
For additional resources, take a look at this article from First Tuesday Journal and this article by Steve Messing. And as always, consult your tax accountant for information specific to your tax situation.