I recently posted on the subject of the ‘Professional Investor’ which garnered many questions. One commenter, Lee, asked a couple great questions which inspired me to expand on a subject she introduced with her questions. Thanks Lee.
Most real estate investors aren’t aware of the benefits of that designation on your tax return, or the unintended consequences of being declared a dealer. Ah, there’s the rub — most investors don’t know what a dealer in real estate is.
The IRS will, at their discretion, determine if a taxpayer is a dealer. Once they make that call the taxpayer will then be paying ordinary income tax rates instead of the much lower long term capital gains rates.
But what the heck is a dealer?!
Dealers buy and sell properties, generally for a profit. They do so as quickly as possible. They’re considered by the IRS as making their living this way. The key factor though is what they’re not — they’re not investors.
You see, investors are long term while dealers are more the get in, get out ASAP variety. The IRS doesn’t want dealers to benefit from the much lower long term capital gains tax rate. In many cases it’s less than half the taxes of what a dealer would pay.
It gets better. The Internal Revenue Code doesn’t make it easy by providing a clear definition delineating the difference between the two. Nnooooo, they prefer the courts to decide, case by case, inch by inch what defines a dealer.
Internal Revenue Code § 1221 says a capital asset is, (in part) “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”
What that means to you is simple — if the property you buy is meant for your ‘trade or business’ and not for investment, you’re gonna be designated as a dealer — at least as far as that particular property is concerned. Your tax rate is then automatically derived from ordinary income tax rates which will almost always be double (usually more than double) the long term capital gains rate.
Paying 30-40% of your profits in taxes isn’t in most investors’ Purposeful Plans.
Also, if you’re a dealer, there will be no tax deferred exchanges for you. Not allowed. That tasty dish just ain’t on your menu. Also, the installment sale treatment is denied the dealer. That means if they carry a note for a part of the sales price it will be treated as if the note was cash. It will be taxed at ordinary rates too.
The investor opting for an installment sale is allowed to pay taxes as they receive the money over time, payable each tax year. There’s a specific formula, different for every property. Each dollar received can be looked at as one, two, or three different ways. Interest, return on capital, and/or return of capital.
Anyone wanna be a dealer?
Rehabbers are dealers — by definition. They buy property, as part of their trade or business, for the expressed purpose of adding value and selling as quickly as possible for a profit. If they could do it every month they would. They buy obvious fixers and proceed to make them pretty.
The IRS says investors buy and hold for appreciation, dividends, (cash flow) and interest. Dealers buy property to sell it for a quick profit.
How long you hold the property and how many properties you’ve been selling lately is what they want to know. The longer you hold the better you look. Don’t think their so called rules are anything but suggestions either, ‘cuz they’re not. If you’ve been buying and selling properties like a dealer, then sell one 14 months after buying it, you’re not in any way, shape, or form guaranteed investor status. In fact I’d bet good money they’re gonna call you a dealer. At that point you’re treated as guilty until you or your CPA or tax attorney prove you innocent. It’s not the hoped for end game — know what I mean, Verne?
The courts don’t make it any clearer either. They add their own brands of mud. Each court decision is yet another layer — and that doesn’t count the courts of appeal. I’ve been asked many, many times about specific cases, and have referred them to tax pros with intensive real estate training in what the Internal Tax Code and court rulings have said — lately. Geez.
Another factor is what the taxpayer does with the property. Did they rezone it? Make massive improvements meant to significantly improve value? Or God forbid, subdivide it? DEALER. Made a bunch of sales lately? Yer probably a dealer then too. (Not the case however, if they were held for say, 3 years or so.)
Purposeful Planning proactively avoids the road leading to Dealerville by preemptive strikes. There’s a river running through Dealerville. It’s the natural border separating the taxpayer from Investor City. (Yeah, I know — way corny, but it works.) Crossing that river without a bridge isn’t recommended. The investor can be a dealer too, but by choice. They might be buying property to rehab and flip. If they held title to that property via an entity which clearly shows the IRS how to differentiate a dealer property from their bona fide investments — everyone’s happy. This is easily accomplished by employing your real estate attorney during the acquisition process, which we do as a matter of course.
This isn’t everything you need to know about being a dealer and/or an investor. But I’ll bet there’s all kinds of folks out there who just realized something chilling. This is another question they didn’t know to ask. That’s not a good thing.
It’s the answers to the questions we don’t know to ask that usually end up biting us where we sit.
And for the record? Real estate investors nearly always do far better over the long haul, (and usually the short haul too) than dealers.