THE IRS REAL ESTATE DEALER STATUS ISSUE
In this edition of the Real Estate Revolution, we will discuss the IRS Real Estate Dealer Status Issue.
Real Estate Dealer Status: The Internal Revenue Code defines a real estate dealer as: "An individual who is engaged in the business of selling real estate with a view to the gains and profits that may be derived from such sales. On the other hand, an individual who merely holds real estate for investment or speculation and receives rentals therefrom is not considered a real estate dealer."
Generally, a person is considered a real estate dealer if he/she has the intent of reselling rather than investment or more specifically if (1) the property is held primarily for sale; (2) the property is held for sale to customers; and (3) the property is for sale in the ordinary course of the taxpayer's trade or business (See, e.g., Winthrop, Ada Belle v. Tomlinson, 417 F.2d 905).
The determination whether your real estate activities rise to the level of a trade or business is a factual one, subject to a number of tests including the nature and purpose of the acquisition of the property, the duration of ownership, the continuity of sales and sales related activities over a period of time, the volume and frequency of sales, the extent of development or improvement on the property, the extent of soliciting customers and advertising, and the substantiality of sales compared with other sources of your income.
Over the past five years we have seen an unprecedented appreciation in real estate values and a surge in real estate activity by investors seeking to capitalize on gains that have outpaced the stock market. This has brought to the forefront the issue of whether a sale of real estate would be treated as ordinary income or capital gains. Most people who bought real estate to "flip" it down the road would expect to pay only capital gains, and if they held it for more than one year, to pay only a 15% personal income tax. Furthermore, they would assume that they would have the option of doing a tax-deferred 1031 exchange or an installment sale. However, an active buyer and seller of real estate may be labeled as a "real estate dealer", which not only leads to negative tax consequences, but also severely restricts flexibility in structuring real estate transactions.
IN SHORT, if a substantial portion of your personal gross sales or net income were derived from real estate sales, then you most assuredly would be considered a real estate dealer.
NEGATIVE CONSEQUENCES OF THE DEALER STATUS
NO 1031 Exchanges:If you are considered a real estate dealer by the IRS, you become ineligible for Section 1031 tax deferred exchanges because the property owned is considered inventory.
Ordinary Income Tax Rates: Classification as a real estate dealer would subject the gain on the property to ordinary income tax rates, which cap out at 35%. Given that long-term capital gains are taxed at 15%, the affect on potential profit margins is quite significant. The use of a corporation will eliminate the self-employment tax for real estate dealers.
Self-Employment Tax: In addition to ordinary income tax rates, a real estate dealer's gain from sale of real estate IS subject to self-employment tax, which currently 15.3%. The use of a corporation will eliminate the self-employment tax for real estate dealers.
IMPORTANT NOTE: The Real Estate Dealer status would NOT apply to you if you operate your real estate business through a corporation.
