When you’re in Real Estate as a Dealer or Investor, and you purchase real property, you undoubtedly have at least a tentative plan for its use. You’re either going to develop it or hang onto it as an investment.
Do you consider the impact it will have on your income taxes when you eventually sell it, though? The IRS has many rules regarding the taxation of real property sales, but it ultimately comes down to this: When you sell it, are you doing so as a dealer or as an investor? You’re going to pay significantly less in taxes if you’re considered an investor for that transaction (you can be a dealer for some sales and an investor for others).
What’s the Difference?
The gains you make when you sell real property you’ve held for more than a year (long-term) are taxed at capital gains rates, which can be 0, 15, or 20 percent, depending on your filing status and your taxable income (short-term capital gains are calculated based on your federal tax bracket).
When you’re considered a dealer, though, the property isn’t considered a capital asset. It’s taxed as ordinary income. You may also be responsible for paying self-employment taxes.
Investor or Dealer?
How do you know which type of seller you are? Unfortunately, as is true with many other elements of the tax code, the answer isn’t black-and-white. This determination is made by both the IRS, spelled out in IRC Section 1221, and the courts.
Here are some of the issues considered when making this distinction:
- How long has the taxpayer owned the property? The IRS will probably classify you as an investor if you’ve bought one piece of property and held onto it for more than a year. Purchase multiple properties and start selling them within the first year, though, and you’re likely to have to pay taxes as a dealer.
- Why was the property purchased and held? This may be hard to prove, but the intent behind the transaction is sometimes considered.
- Has the taxpayer made obvious efforts to sell the property or portions of it? This would include advertising, listing through brokers, establishing a business office, etc.
- How much has the property been improved, and how quickly? Rapid enhancements, subdividing, and other development can indicate that the owner is a dealer.
- Does the taxpayer represent himself or herself as a dealer? Sometimes, it’s obvious.
A Difficult Distinction
Identifying yourself as either a dealer or an investor isn’t always a complex issue. But it can be. It’s something you should be keeping in mind from the time you decide to purchase real property, and certainly a consideration in your selling process.
We’ve worked with individuals who have had to grapple with this distinction, and we understand that making the right determination will have tremendous impact on your income tax liability. Contact us if you want to discuss your own situation as it applies to IRS regulations.