By If you buy and sell real estate, you need to know the difference between being classified for tax purposes as a real estate dealer versus a real estate investor.
- Real estate dealers are in the business of buying and selling real property—property is their inventory.
- Real estate investors own property primarily to earn income from rents and/or long-term appreciation. Their real estate activity is not a business.
Why is this distinction important? Because dealers and investors receive very different tax treatment. As business owners, dealers pay taxes on their profits at ordinary income rates, which can be as high as 37 percent. They also pay self-employment taxes.
Real estate investors pay taxes on their profits at capital gains rates and pay no self-employment tax. If they hold their property for over one year, they pay tax at long-term capital gains rates of 0, 15, or 20 percent. They may also have to pay the 3.8 percent net investment income tax (NIIT).
The difference in tax rates can have a big impact if you sell real property at a substantial profit. For example, if you earn a $100,000 profit from the sale of a property held for over one year, your taxes as a dealer could be as high as $51,130 (37 percent income tax + 14.13 percent self-employment tax). If you’re an investor, your taxes could be as high as $23,800 (20 percent capital gains tax + 3.8 percent NIIT). That’s a $27,330 difference.
Dealers may also not deduct depreciation, use installment sales, or defer tax through Section 1031 tax-deferred exchanges of their property.
Things are not all bad for real estate dealers. Unlike investors, they may fully deduct their losses. Investors may deduct no more than $3,000 in losses from ordinary income (after offsetting gains against losses).
Unfortunately, the tax code does not provide a definition of “real estate dealer.” Instead, the IRS and the courts look at various factors, including:
- How many of your properties do you sell, and how frequently?
- Did you buy with the intent of reselling at a profit?
- Did you improve the property to increase its resale value?
- What is the extent of your sales efforts?
- How did you acquire the property?
- How long did you hold the property before selling it?
- How much time did you spend selling the properties?
- What portion of your income comes from selling your properties?
Real estate dealers typically include (but are not limited to),
- real estate flippers—people who buy homes, fix them up, and resell them quickly;
- real estate speculators, who buy and sell many properties each year;
- subdividers, who buy large tracts of vacant land, divide them into smaller lots, and then resell the lots piecemeal; and
- real estate developers and home builders, who construct new houses and resell them soon after completion.
To make things even more complicated, you can own some property for sale as a dealer and other property as a long-term investment. Whether you are a dealer is determined on a property-by-property basis. If you have dealer and investor properties, you should keep separate books, records, and bank accounts.
If you want to discuss your real estate properties, please call me on my direct line at 408-778-9651.