Are You a Dealer or Investor?

You can change your income taxes dramatically by being a real estate dealer rather than a real estate investor, or vice versa.  You may, or may not, want a dramatic change in your taxes.

This article will help you avoid those unwanted and dramatic changes caused by an incorrect investor or dealer classification.  This article focuses on the real estate investor and the real estate dealer, but the same dealer and investor principles apply to sales of artwork, classic cars, stocks and bonds, commodities, and most other things you can think of.

Planning in this area can produce big dividends, so learn the classification you prefer, and which one you fall under.  Neither the law no the regulations lay down a framework for you to follow; accordingly, you have to go to court precedent as a guide.

This article shows

1.   some benefits of being either a dealer or an investor,

2.   how to choose which you want depending on the circumstance, and

3.   how to make sure you avoid incorrect classification.

Big Time Tax Consequences

Profits on dealer sales are generally subject to taxes at both

• ordinary income rates of up to 35%, and
• self-employment rates of up to 15.3%.

In addition, dealers may not

• depreciate the property that they hold for sale to customers,
• use the tax-favored installment method to report their property dispositions, or
• defer taxes using the Section 1031 tax-deferred exchange on dealer properties.

For dealers, two good things happen for tax purposes.  First, dealers treat real estate selling expenses, commissions, legal fees, and advertising as ordinary business deductions.  Second, losses on the sale of dealer properties are not limited by the $3,000 capital loss cap that exists for investor properties.

Profits on investor sales are

• taxed at tax-favored capital gains rates of 15% or less, and
• not subject to self-employment taxes.

Example:  You have a $90,000 profit on the sale of a property.  Dealer taxes could be as high as $36,370.  Investor taxes could be as high as $13,500.  The difference: a whopping $22,870.  Tax knowledge is valuable stuff.

In addition to this tax difference, remember the investor in a rental property

• would depreciate the property,
• could sell using the tax-favored installment method, and
• could defer the taxes by using the Section 1031 tax-deferred exchange.

Yes, tax law treats investors kindly, especially on profits.

On losses, dealers have the advantage over investors.  When a property sells at a loss, the dealer:

• deducts the loss as an ordinary loss, and
• deducts the entire loss (immediately or over time using the net operating loss rules that allow carryback two years and carryforward 20 years).

Investors face the $3,000 limit on net capital losses (after offsetting gains against losses).

Investors also suffer the disadvantage of treating selling expenses as reductions in sales proceeds, meaning that selling expenses produce benefits only at capital gains tax rates.  Dealers come out ahead here.  Dealers treat selling expenses as ordinary deductions, meaning that dealers reap benefits from selling expenses at the combined self-employment and income-tax rates.

Part Dealer and Part Investor

You, the individual taxpayer, can be both a dealer and an investor!  The law does not cut you in half or anything.  No, the law simply looks at each property in its respective light.  But you need to make the light shine on your properties by making a clear distinction in your books and records as to which properties are investment properties and which properties are dealer properties.  Should you fail to make the distinction, you place yourself at the mercy of the IRS.  (The word mercy does not exist in the tax code, so expect a very unhappy result if you rely on mercy.)

The courts look at your intent in buying and holding the property.  Your books and records help establish that intent.

Notice the word “help”.  Your purpose in buying and holding does not control, it only helps.  When push comes to shove, the courts examine the sale when they rule on dealer or investor status.

So set yourself up to make a strong case.  Establish your intent

• when you buy the property,
• while you own the property, and
• when you sell the property.

This article helps you do this.

True, circumstances can change.  You may buy the property for one purpose and then something happens to change your purpose.  This article will help you realize what that change means and how, if at all, you can plan for a better result.

Before getting to the planning part of this article, which revolves around the attributes of a dealer or an investor, you need to focus on one major point in time.  That one point is the way your property looks at the time of sale.  This look gets the full focus of the IRS and the courts and often determines its classification as dealer or investor property.

The attributes of a dealer and the attributes of an investor that follow will help you look at your property in the proper light.

Attributes of Dealer Property

Each property stands alone as a dealer or investor property.  Your property might possess some attributes of a dealer property and some attributes of an investor property.  With mixed attributes, the court will base its decision on the court’s interpretation of your facts as to this property.

This leads you down a road filled with potential potholes and, possibly, even a few cliffs.

But most people who have trouble with the dealer and investor property have that trouble after the fact, meaning they did not know what they were doing at the time they did it.  You will not have this problem.  This article gives you a clear understanding of how your property could be classified as a dealer or investor property.  Then once you have the differences clearly in mind, you simply plan as many of the appropriate attributes as possible on your property.

Dealer property is property you hold for sale to customers in the ordinary course of a trade or business.

The more properties you buy, and the more properties you sell during a calendar year, the greater the chances that you are a dealer with respect to those properties.

If you are hoping that the courts, IRS, or some other friendly critter has set the number of transactions that classify property as dealer property, you are hoping wrong.  No such number exists.

Just to make sure that you don’t even think of some magic number, the courts have ruled that

·         one sale earned the taxpayer dealer status because, before the property’s acquisition, the taxpayer agreed to sell the property to a third part, and

·         the sale of 90 homes in one year did not earn dealer status for Goldberg.

To show you how things can get confused, the Goldberg case was decided against Goldberg by the Tax Court and then overturned by the Fifth Circuit.  In Goldberg, the homes were built as rentals during World War II.  When the war ended, rentals ended, and thus the homes could be, and were, sold.  Here, the homes were

• built for rental,
• used for rental,
• sold.

The homes were never built for resale to customers in the ordinary course of business.

From all of this, you can rightly conclude that there is no right number of sales and purchases that automatically makes property dealer or investor property.  But the general rule that you can see by reviewing a great number of court cases is that the greater the number of properties bought and sold, the greater the chances that these are dealer properties.

Properties that you buy, fix up, and sell are generally dealer properties.  Also, properties that you subdivide have great chance of being dealer property, except subdivisions done under the very limited rules of Section 1237.  Even the removal of the lien to make the property more salable can indicate dealer status.

Sales efforts can indicate dealer status.  The courts often declare properties dealer properties when the taxpayer engages in extensive marketing and sales efforts, especially compared to the taxpayer who takes a passive marketing approach.

Properties held for short periods of time indicate dealer status.  The courts know that good cash and profit management make the dealer want to turn over the properties in a hurry.

If you generally make your living from dealer income, your properties are more likely to be classified as dealer properties by the courts.  Making a living is only one measure of dealer status; time spent also is an important factor.  If you spend the majority of your time buying and selling property for your own account, your properties are looking a lot like dealer properties.

If you sell the property and take the proceeds from the sale to purchase additional real estate, the court is more likely to conclude that you are a dealer, rather than an investor.

We have just covered the attributes that could make some or all of your properties into dealer properties.  The fact that a property carries the taint of one dealer attribute does not, by itself, make that property a dealer property.  Further, the fact that your portfolio contains dealer properties does not mean that your portfolio may not also include investor properties.  Remember, each property stands alone.

When you look at the dealer attributes and how they apply to your property, think of those attributes as signs on the road to help you get to your destination.  Try to get the signs to line up for your property, from the time you buy it until you sell it.

Attributes of Investor Property

Unlike dealer property, where the dealer’s principal purpose for owning the property is to sell the property to customers in the ordinary course of business, your purpose in owning investor property is to

·         have it appreciate in value, or

·         produce rental income.

Investor properties are sold infrequently.

Properties bought for the primary purpose of producing rental income are investor properties.

Generally, the courts deem that you hold property as an investor when you acquire the property by

• inheritance, or
• dissolution of a trust, or
• foreclosure of a mortgage.

You can even make significant improvements to the decendent’s real estate and still realize investor status.  But be careful here.  Should you sell the decendent’s real estate and then reinvest the proceeds in other real estate, you will have a much harder time convincing the court that you are merely an investor.  Further, should you now start subdividing the land and otherwise act as a dealer, the courts will make you a dealer.

In general, investors hold property longer than dealers.  And the longer your holding period, the better the chances that your property is investment property.

The investor does not buy, remodel, and then sell.  Investors may remodel, but investors remodel to realize an increase in rental income.  They do not remodel for the sole purpose of selling the property in the ordinary course of business.

Summary

Each property stands alone with respect its status as a dealer or investor property.  Thus, you, the individual taxpayer, or your corporation may own both dealer and investor properties.  In such a case, make absolutely certain that you are classifying your properties correctly.  The tax consequences are enormous.

Keep two general rules in mind: First, the dealer buys property for the purpose of reselling the property to customers in the ordinary course of business.  Second, the investor buys property for appreciation, rental income, or both appreciation and rental income.

If your property does not fall at one end of the spectrum, make sure your property meets as many of the attributes for your desired outcome as possible.

Information provided by Tax Reduction Letter, Volume 14, Number 8, August 2005