People who buy and sell (or “flip”) real properties often call themselves real estate “investors”. But this may not be a correct definition in the eyes of the IRS. The IRS will often seek to determine whether these taxpayers are operating as “dealers” or “investors”. Should you be classified as a dealer, you are deemed to be in an active trade or business. We will discuss why this is an important distinction.
Is There Investment Intent?
Determining dealer status is often difficult. If you buy and sell properties on a daily basis then the IRS may take the position that this is your business activity. For example, this would be similar to a CPA who charges clients a fee for his or her services. If the CPA does a real estate deal or two on occasion when he or she could more easily be considered an investor because the activity is not necessarily part of a normal trade.
The reason why this is significant is that dealers will be subject to employment taxes at the rate of 15.3% of business profits (assuming a sole proprietorship). This would be consistent with any other normal business owner. In addition, dealers do not have the ability to utilize the installment method for sales of real estate. This means that if you dispose of a property and take payments over a long period of time you will have to pay tax on the sale immediately as opposed to deferring the profits into the future.
How is Investment Intent Determined?
While it is certainly a subjective issue, the IRS looks to the “intent” of the taxpayer. Specifically, the following criteria are often examined:
- Purpose for which the original acquisition was made
- Duration of ownership and the purpose for which it was sold
- Frequency and continuity of sales
- The extent to which improvements (if any) were made to the property
- Control and effort expended by the taxpayer in the sales process
- Use of real estate brokers and extent of advertising initiatives
- Ordinary business and experience of the taxpayer
- Nature of the taxpayer’s other real estate holdings
- Income from the sale compared to other sources of income and employment
- Reluctance or desire to dispose of the property
Considering the above criteria, one of the most important issues appears to be the taxpayer’s volume, frequency, and consistency of real estate sales. Said differently, if you have a history of selling a lot of properties and do not have other business activities then this may weigh in favor of you being a dealer.
But just because the IRS may consider you a dealer with respect to a property or certain properties, it may not make you a dealer on all your properties. It may be advantageous to have certain flips grouped in one taxable entity (for example an LLC possibly taxed as an S Corp) and have “buy and holds” in a separate entity. Accordingly, having a formal structure in place may allow the IRS to look favorably at the taxpayer’s investment intent.
About the Author:
Paul Sundin is a CPA and tax strategist at www.sundincpa.com. He does tax planning for business owners, real estate entrepreneurs and individuals.