Defining “Real Estate Investor” and “Real Estate Dealer”
Let’s start with the big-time tax consequences of distinguishing between these two classifications.
Profits on dealer sales by individuals are generally subject to taxes at both
- ordinary income rates of up to 37 percent,1 and
- self-employment rates of up to 14.13 percent.2
In addition, dealers may not
- depreciate property held for sale to customers,
- use the tax-favored installment method to report their property dispositions, or
- use Section 1031 to defer taxes.
Good Tax Breaks for Dealers
Tax law treats the 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 can trap investor properties.
- Dealers deduct losses as ordinary losses.
- Dealers deduct the losses, generally immediately (but if the losses creates a net operating loss, then over time).3
Good Tax Breaks for Investors Profits on investor sales are
- taxed at tax-favored capital gains rates of 23.8 percent or less, and
- not subject to self-employment taxes.
Say you have a $90,000 profit on the sale of a property.
- Dealer taxes could be as high as $46,017.4
- Investor taxes could be as high as $21,420.5
The investor living in the highest federal tax rate saves $24,597 in taxes (a goodly sum). In addition, the investor
- depreciates the property,
- may sell using the tax-favored installment sales method, and
- may defer the taxes by using the Section 1031 tax-deferred exchange.
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 Can Be Part Dealer and Part Investor
You, the individual taxpayer, can be both a dealer and an investor! The law looks at each property separately.6
To make this work to your advantage, you need to shine a light 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 in your books, you place yourself at the mercy of the IRS. (The word “mercy” does not exist in the tax code—we know, because we searched—so expect a very unhappy result if you rely on mercy from the IRS.)
The courts look at your intent in buying and holding the property. Your books and records help establish intent.
Notice the word “help.” Your purpose in buying and holding does not control. It only helps. When push comes to shove, the courts examine the sale when they rule on your property and its dealer or investor status.7
Set yourself up to make a strong case. Establish your intent
- when you buy the property,
- while you own the property, and
- when you sell the property.
This article helps you do that.
True, circumstances can change. You may buy the property for one purpose, and then something may happen to change your intention. This article will help you realize what that change means and how you can plan for a better result.
The Critical Point-of-Sale Aspect
Before getting to the planning part of this article, which revolves around the attributes of a dealer and an investor, you need to focus on one major aspect: how your property looks at the time of sale. This point-of-sale look gets the full focus of the IRS and the courts, and often it determines the property’s classification as dealer or investor property.
Understanding the attributes of a dealer, described below, and the attributes of an investor that follow will help you look at your property in the correct light.
Determining Tax Attributes of Your Property
Remember, each property stands alone as a dealer or an investor property.
Your property might possess some attributes of a dealer property and some attributes of an investor property. When your property exhibits mixed characteristics, the court will base its decision on its interpretation of your facts as to the property.
Allowing the court to do this for you is a bad idea.
Most people who have trouble with the dealer and investor property classifications have that trouble after the fact, meaning they do not know what they are doing beforehand.
You will not have this problem, however, because you will learn how the tax rules can classify your property as dealer or investor property. Then, once you clearly understand the differences, you can plan appropriate attributes for your property.
The Real Estate Dealer’s Tax Attributes
“Dealer property” is property you hold for sale to customers in the ordinary course of a trade or business.8
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.9
If you are hoping that the courts or the IRS have set the number of transactions that classify property as dealer property, you are flat out of luck. No such number exists.
To make sure that you don’t even think of some magic number, the courts have ruled as follows:
- One sale earned S & H, Inc., dealer status because—
before the property’s acquisition—S & H agreed to sell the property to a third party.10 ·
- And yet the sale of 90 homes in one year did not earn dealer status for Nathan Goldberg.11
To show you how things can get confused, the Goldberg case was decided against Nathan Goldberg by the Tax Court and then overturned by the Fifth Circuit. In Goldberg, the homes were built as rentals during World War II. When the war ended, rentals ended, and thus the houses could be (and were) sold. Here, the homes were
- built for rental,
- used for rental,
- and sold.
The homes were never built for resale to customers in the ordinary course of business.
From all this, you can rightly conclude that no right number of sales and purchases automatically makes property a dealer or an investor property.
But the general rule you can recognize by reviewing a great number of court cases is that the greater the number of properties bought and sold, the greater the chances that these are dealer properties.
A property that you buy, fix up, and sell generally is a dealer property.12
Also, a property that you subdivide has a great chance of being a dealer property,13 except when the subdivision is done under the very limited rules of Section 1237.14
Even the removal of a lien to make the property more salable can indicate dealer status.15
Sales efforts can indicate dealer status. The courts often declare a property to be a dealer property when the taxpayer engages in extensive marketing and sales efforts, especially compared with the taxpayer who takes a passive marketing approach.16
A property held for a short period indicates dealer status.17 The courts know that good cash and profit management make the dealer want to turn over the property quickly.
If you generally make your living from dealer income, your properties are more likely to be classified by the courts as dealer properties.18
Making a living is only one measure of dealer status. Time spent is also an important factor. If you spend most of your time buying and selling property for your own account, your properties look like dealer properties.19
If you sell a property and take the proceeds from the sale to purchase additional real estate, the court is more likely to conclude that you are a dealer rather than an investor.20
Tainted by a Dealer Attribute
We have just covered the attributes that could classify some or all of your properties as dealer properties. But the fact that a property carries the taint of one dealer attribute does not make that property a dealer property.
Further, the fact that your portfolio contains dealer properties does not preclude your portfolio from also including investor properties. Remember, each property stands alone.
When you look at the dealer attributes and how they apply to your property, think of them as signs on the road to help you reach your destination. Try to get the property attributes lined up from the time of purchase through the time of sale.
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 and/or
- produce rental income.
Investor properties are sold infrequently.21
Properties bought for the primary purpose of producing rental income are investor properties.22 Generally, the courts deem that you hold property as an investor when you acquire the property by
- dissolution of a trust,24 or
- foreclosure of a mortgage.25
You can even significantly improve a decedent’s real estate and still realize investor status.26 But be careful here. Should you make substantial improvements and then sell the decedent’s real estate and reinvest the proceeds in other real estate, you will have a more challenging time convincing the court that you are merely an investor.
Further, should you now start subdividing the land and otherwise act as a dealer, the courts will make you a dealer.27 But for how you can possibly do this, see Selling Appreciated Land? Use the S Corporation to Lock in Favorable Capital Gains Treatment.
In general, investors hold the property longer than dealers do. And the longer you hold property, the better the chances that your property is investment property.28
The investor does not buy, remodel, and then sell. Investors may remodel, but they do so to realize an increase in rental income. They do not remodel for the sole purpose of selling the property in the ordinary course of business.29
Keep two general rules in mind:
- The dealer buys property to resell the property to customers in the ordinary course of business.
- The investor buys property for appreciation, for rental income, or for both purposes.
If your property does not fall at one end of the spectrum, make sure it meets as many of the attributes for your desired outcome as possible.
Each property stands alone regarding its status as a dealer or an investor property.
Thus, you (the individual taxpayer) or your corporation may own both dealer and investor properties.30 In such a case, make certain that you are classifying your properties correctly. The tax consequences of failing to do so are enormous.
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.
1 2023 Federal Tax Rates.
2 Self-employment rate of 15.3 percent times the 92.65 percent Schedule SE adjustment equals the effective rate of 14.13 percent. 3 IRC Section 172(b)(1)(A)(ii).
4 For instance, if you were married to a spouse with good income, this was your only income taxed at the highest federal rate of 37 percent, and you also paid self employment taxes at 14.13 percent.
5 Here, you have the 20 percent capital-gains rate plus the 3.8 percent net-investment income tax.
6 Tollis v Commr., T.C. Memo 1993-63.
7 Sanders v U.S., 740 F.2d 886.
8 IRC Section 1221(a)(1).
9 Sanders v U.S., 740 F.2d 886; Suburban Realty Co. v U.S., 615 F.2d 171.
10 S & H, Inc. v Commr., 78 T.C. 234.
11 Goldberg v Commr., 223 F.2d 709, 55-1 USTC paragraph 9519 (5th Cir. 1955).
12 Jarret v Commr., T.C. Memo 1993-516.
13 Rev. Rul. 57-565 allowed capital gains treatment for the land not subdivided when the taxpayer had subdivided 40 percent into lots and sold those lots. 14 IRC Section 1237.
15 Miller v Commr., T.C. Memo 1962-198.
16 Hancock v Commr., T.C. Memo 1999-336.
17 Stanley Inc. v Schuster, aff’d per curiam, 421 F.2d 1360, 70-1 USTC paragraph 9276 (6th Cir.), cert. denied, 400 US 822 (1970); 295 F. Supp. 812 (S.D. Ohio 1969).
18 Suburban Realty Co. v U.S., 615 F2d 171.
19 Armstrong v Commr., T.C. Memo 1980-548.
20 Mathews v Commr., 315 F2d 101.
21 Rymer v Commr., T.C. Memo 1986-534.
22 Planned Communities, Inc. v Commr., 41 T.C.M. 552.
23 Estate of Mundy v Commr., 36 T.C. 703.
24 U.S. v Rosebrook, 318 F.2d 316, 63-2 USTC paragraph 9500 (9th Cir. 1963).
25 Cebrian v U.S., 181 F. Supp 412, 420 (Ct. Cl. 1960).
26 Yunker v Commr., 256 F.2d 130, 1 AFTR2d 1559 (6th Cir. 1958).
27 U.S. v Winthrop, 417 F.2d 905, 69-2 USTC paragraph 9686 (5th Cir. 1969).
28 Nash v Commr., 60 T.C. 503, acq. 1974-2 CB 3.
29 Metz v Commr., T.C. Memo 1955-303.
30 Harbour Properties, Inc. v Commr., T.C. Memo 1973-134; Howell v Commr., 57 T.C. 546; Real Estate Corp. v Commr., 35 T.C. 610 (1961), aff’d, 301 F.2d 423 (10th Cir. 1962); Mieg v Commr., 32 T.C. 1314 (1959).