Well, as with most tax questions, the answer is, it depends.
Investor vs. Dealer.
When we think of a real estate investor, we think of someone who purchases and holds real estate for rental income and/or appreciation over a period of time. A typical investor might own a few rental properties, keep them for several years and eventually sell them. An investor is thought of as being in it for the long term.
Being a real estate dealer is more involved. The IRS considers a dealer to be someone who is engaged in the business of selling real estate to customers with the purpose of making a profit from those sales, such as flipping and wholesaling. A dealer is more of a short term proposition. Determining who is a dealer is subjective and open to interpretation. The IRS and the courts use several factors that have been developed through numerous court cases. These factors are:
- The taxpayer’s purpose in acquiring the property;
- The purpose for which the property was subsequently held;
- The taxpayer’s everyday business and the relationship of the income from the property to the taxpayer’s total income;
- The frequency, continuity, and substantiality of sales of property;
- The extent of developing and improving the property to increase the sales revenue;
- The extent to which the taxpayer used advertising, promotion, or other activities to increase sales;
- The use of a business office for sale of property;
- The character and degree of supervision or control the taxpayer exercised over any representative selling the property; and
- The time and effort the taxpayer habitually devoted to sales of property.
No one of these factors is, by itself, conclusive in determining if you are a dealer. However, the Tax Court has indicated that the frequency, continuity, and substantiality of sales of property are the most important factors to consider.
Tax consequences of being an investor vs. a dealer.
For an investor, rental income is generally taxed at ordinary income rates and is not subject to self-employment tax (Self-employment tax is a tax of up to 15.3% on your net income from self-employment. Self-employment tax is in addition to your regular income tax). If you hold your investment property for at least a year, your gain on sale will be taxed at favorable long term capital gain rates.
If you are classified by the IRS as a dealer, all of your income will be taxed at ordinary income rates. There is no favorable long term capital gain treatment. Installment Sales and Like Kind Exchanges are not available to dealers. Additionally, you will be subject to self-employment tax on your profits.
If the IRS classifies you as a dealer, then all of your real estate income, including rental income, will be subject to dealer treatment. To avoid this treatment, it is important to use separate entities for different types of real estate activities. The best example of this would be holding rental properties in an LLC while using an S-Corporation for wholesaling and flipping.
As always, this is only meant as a brief overview. If you feel that we can be of further assistance to you, please contact our office to set up an appointment.
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- Doherty & Associates Team