Investor or Dealer? Why It Matters in the Sale of Real Property
When it comes to the sale of real property, determining whether you're a dealer or an investor could be a million-dollar question. Here's what you should know about this highly litigated area of tax.
You’ve just sold a piece of property. Now, the million-dollar question: Does the resulting gain count as ordinary income or capital gain?
In nearly every case, the latter is much more tax advantageous.
That’s because ordinary income tax rates top out at 39.6 percent, whereas the highest capital gain rate is 20 percent. Considering the difference between the two rates, it really could be a million-dollar question. The answer lies in whether the IRS recognizes you as a dealer or an investor in the sale. (Dealers are subject to ordinary income tax rates; investors receive the more favorable capital gain treatment.)
Generally speaking, if the IRS believes you held the property as an investment, you’ll be considered an investor. But if you held the property primarily for re-sale, you can expect to be seen as a dealer. As you might expect, the investor vs. dealer status is frequently litigated. Here’s what you should know about it:
There are several factors the IRS will weigh in determining whether you qualify as a dealer or an investor. The most important, according to the courts, is the frequency of sales. If you’re constantly buying and selling real estate instead of holding on to it over the long term, you may find it hard to avoid dealer status. The IRS will also want to know the following:
- What was the nature and purpose of the acquisition?
- How long did you hold the property?
- How involved were you in the sale of the property? How much time did you spend listing, advertising, and showing it?
- Did you make several improvements or modifications to the property in order to increase sales?
- Did you use a business office to sell the property?
- What level of control did you have over any representative whom you hired to sell it?
Here are a few things you can do to support your case:
- Structure your partnership agreement and contracts accordingly. Explicitly state that the entity’s purpose is to invest in real estate, and that you acquired the property for investment purposes. Also, be sure to avoid using “developer” or “development” to describe the acquisition.
- On your tax return, make sure the particular assets appear on your balance sheet as investments and NOT as inventory or work in progress.
- Always do business in the investment entity’s name.
It pays to plan ahead.
The dealer vs. investor classification is not a black and white issue. Planning, especially on the front end, is critical and can dramatically change the outcome for income tax purposes. Contact your CPA to discuss your options.