Defining “Real Estate Investor” and “Real Estate Dealer”

First good news… you can be both real estate investor and real estate dealer with respect to your real estate portfolio.

Let’s start with the big-time tax consequences.

• Profits on dealer sales are generally subject to taxes at both ordinary income rates of up to 37 percent,
• and self-employment rates of up to 15.3 percent.
• In addition, dealers may not depreciate property held for sale to customers,
• may not use the tax-favored installment method to report their property dispositions,
• and may not defer taxes by using the Section 1031 tax-deferred exchange on dealer properties.

Tax Breaks for Real Estate Dealers

Tax law treats the real estate dealer just as it does any business, and that includes some good things for tax purposes.

• Dealers treat real estate selling expenses, commissions, legal fees, and advertising as ordinary business deductions.
• Losses on the sale of dealer properties are not limited by the $3,000 capital loss cap that exists for investor properties.
• Dealers deduct the loss as an ordinary loss.
• Dealers deduct the entire loss either immediately or over time using the new net operating loss rules that allow carryforward forever.

Good Tax Breaks for Real Estate Investors

Profits on investor sales are

• taxed at tax-favored capital gains rates of 20 percent or less,
• and not subject to self-employment taxes.

The next good news is that you are in control, and by knowing just a few rules about dealer and investor classifications, you can do much to increase your net worth.

Let’s take a quick look at how big a difference you can make
in the tax bite. Say you have a $90,000 profit on the sale of a property.

• Dealer taxes could be as high as $46,017.
• Investor taxes could be as high as $18,000.

The investor potentially saves a whopping $28,017 in taxes.

In addition, the investor

• depreciates the property,
• may sell using the tax-favored installment method,
• and may defer the taxes by using the Section 1031 tax-deferred exchange.   But:
• 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.

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 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.

Attributes of Dealer 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.

Properties that you buy, fix up, and sell generally are dealer properties.

Also, properties that you subdivide have a great chance of being dealer property, except when those subdivisions are done under the very
limited rules described in the tax code.

The Real Estate Investor’s Tax Attributes

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

• have it appreciate in value, and/or
• produce rental income.

Each property stands alone with respect to its status as a dealer or an investor property.

Thus, you (the individual taxpayer) or your corporation may own both dealer and investor properties. If you have both types of properties, make a clear distinction in your books and records as to which properties are
investment properties and which are dealer properties.

If you want my help with your property classifications, please give me a call on my direct line at 509-543-7600.