Are You a Real Estate Investor or a Dealer?
Big tax advantages can result if you plan your real estate purchases or “flips” in advance
Many people like to own real estate because profits accumulated and are not taxed until sold, and then you can pay only 15% capital gains rates on that profit. But is that really the best tax planning for you? Perhaps you will do much better by structuring yourself as a “dealer”, meaning someone that sells real estate often. The best example is the purchase of a cosmetically unattractive house, which can be dressed up and “flipped”. The current market for “flips” actually can offer some opportunities.
Here are the basic rules about selling real estate. Upon resale, one of four things happens:
|1. Resale of your residence (if you qualify)||Total forgiveness of your tax.|
|2. Investor buy and sale of realty||Capital gains treatment of profits (after a year)|
|3. Investor sale before holding for a year.||Short term capital gain|
|4. Dealer sales- property is treated as inventory||Both gains and losses are ordinary income or loss.|
What is the difference?
- If you are an investor, your sale of realty netting you 100,000 profit/gain will cost you $20,000 capital gain tax.
- If you held the property less than a year, you have short term capital gain, which is taxed at your regular earnings rate of 35%.
- If you are a dealer, your $100,000 profit will be taxed at your personal tax rate of 35%, or $35,000. Plus, since this is ordinary income, you will owe self-employment tax, Medicare tax and, assuming you are already paid up for the year for the old age and survivor taxes, the Medicare tax brings you up to 38% tax rate. This is a 23% rate differential!
However, if you have a $100,000 loss:
- As an investor, you have a capital loss. If you have other capital gains that year, you can net them together. But in this market, you may be selling all of your “flips” at a loss, just to get out. So you risk wasting your capital losses. You may carry your loss forward to subsequent tax years, but only use $3000 per year, and must carry the balance forward to use year after year till consumed, about 39 years.
- As a dealer, if your property is now classified as inventory, all loss is fully deductible at your 35% rate on your tax return (assuming you have gains from work sources to soak up the loss). There is no $3000 per year limit, there is no one year holding period, and as a business loss, it is deductible against other business income.
Let’s look at an example. We’re assuming that Doctor Dora is operating her practice from the safety of an LLC (Limited Liability Company), which means that profits and losses flow directly to her. A solely owned LLC is treated for tax purposes as a disregarded entity… as if it were not there.
Doctor Dora invests in old homes in the historical area near her residence. She and her friends make cosmetic changes and repaint, and typically resell a home for a profit of $100,000. She typically sells three or four a year. If the market is sluggish, she may rent a house, and then resell at the end of lease. Assume she made $300,000 this year, and is in the 35% bracket, and her office has paid her social security requirements through payroll.
As an investor, she would pay 15% of her gain of $300,000, or $45,000 in capital gains tax. She has no other capital losses this year, so she pays the full amount. If Dora holds the house for less than a year, she pays short term capital gains, or 35% of $300,000, or $105,000. Clearly it pays to sit on a house until a year is finished.
As an investor, if she got caught in the credit crunch, sold early, and had to sell all her houses for a total loss of $100,000, she could only deduct the $3000 per year until long into the future.
As a dealer, wearing another hat, so to speak, she must demonstrate a longer pattern of investment in
realty with some consistent business behavior, showing that the interaction with the real estate – e.g. rehabbing, activities of a rental business, or purchasing to compile property for a larger re-subdivision later – is the purpose of buying. Investment is passive; “dealing” is interactive.
Thus, with the same gains shown above of $300,000, as a dealer, Dora will pay ordinary income rates of 35% (105,000), plus 2.9% Medicaid ($8700) for a total of $113,700. This is compared to $45,000 as investor, or $105,000 as short term capital gain investor.
BUT… if Dora is only able to sell at a total loss of $100,000, her loss will be able to be netted against her annual earned income of $500,000, as other business loss. [This is blithely ignoring the issues of AMT and other aspects of tax law that affect Dora as a self employed businesswoman. The capital gains computations are all about arriving at AGI… adjusted gross income, which is the beginning point before other taxes, credits, and exemptions.]
IRS looks for a steady pattern of behavior in dealing with your real estate. And of course, you can be both an investor and dealer… but you must be able to demonstrate a pattern as to each cluster or entity of parcels:
How do you demonstrate to IRS that you are an investor?
- It is ok if you have another full time business as your primary income source.
- Are you fixing up a property to hold for longer term appreciation?
- The transfers in question were perhaps unexpected… an inheritance, divorce, partial gift to family.
- You may use the installment plan to spread payments and gain over several years.
How do you demonstrate to IRS that you are a dealer?
- It is ok if you have another full time business as your primary income source. You must demonstrate that you are running your real estate projects as a second active business.
- Do you perform several buy-fix-sales in the same tax year?
- Can you demonstrate that you were holding the sold property in question as an asset primarily for sale in this business?
- Was the sale of this property ordinary or typical of the types of sales you are doing?
- Is there a continuity of sales over a protracted period of time?
- Are you doing development or rehab projects as a continuing sequence of years?
You may not do sales on the installment plan to spread your gain.