Investors and dealers
Most real estate investors are aware of the advantages of the “investor” designation on their tax return. “Investor” is indicative of a rentier who parks their wealth, lays back and lives off its income.
However, when a property sells, many investors do not weigh the potentially negative consequences of the Internal Revenue Service (IRS) declaring their activities as that of a “dealer” in a business generating personal income from their real estate efforts.
When a property is sold, considerable tax reporting differences exist which distinguish the owner’s dealer property operations from investment property holdings. Earnings on the sale of an investment property, being the spread between the price paid and the greater price received on its sale, are taxed at a low capital gains rate when the property is owned for at least one year.
Conversely, earnings on the sale of dealer property are treated as part of the owner’s efforts in their trade or business. Thus, the earnings are from personal efforts and taxed at higher ordinary income rates — regardless of the length of time the property is owned.
Of course, an investor may own investment property and dealer property concurrently. Managing ownership of both dealer and investor properties makes it more difficult to prove that the sale of an “investment property” is a capital asset subject only to capital gain rates, rather than the sale of inventory in a buy-sell business whose earnings are from personal efforts and taxed as ordinary income.
The property’s intended use
Real estate held by an owner primarily for investment and profit is classified as a capital asset. Capital assets include properties which are:
- actively operated as rentals whether or not directly managed by the owner (passive income category); or
- held as management-free investments for income or profit, such as net-leased property (portfolio income category).
Properties in both passive and portfolio income categories are also classified as §1031 investment properties. [26 United states Code §1221(a)(1)]
The §1031 profit tax exemption includes real estate used as an asset in a trade or business, which are treated the same under §1031 as is a capital asset. Real estate is classified as a trade or business asset if it is:
- used to house or facilitate the operation of an owner’s trade or business; and
- owned for greater than one year.
The only distinctions for a §1031 business asset from a §1031 investment property are:
- the business use of the property; and
- a one-year holding period imposed on business-use property prior to sale or exchange.
On the other hand, real estate held primarily as inventory for sale to others in the ordinary course of the owner’s trade or business provides the owner with personal income as an ordinary income asset, more commonly called dealer property. [26 USC §§64, 1231(b)(1)(A), 1231(b)(1)(B)]
An ordinary income asset typically includes inventories purchased and then actively sold at an increased price. The buying and selling of an ordinary incomes asset to generate income is construed as a business activity, not a rental activity designated a passive business opportunity or an inactive portfolio holding. Inventory classified as an ordinary income asset includes:
- developable or subdividable land which is actively managed toward those ends;
- lots sold in cash-out sales by a developer; or
- properties acquired primarily for resale whether or not they are rented prior to sale.
Properties purchased through a short sale, at a foreclosure sale or from real estate owned (REO) lender inventory qualify as inventory when acquired with the primary intent of cashing out on an eventual resale — the end goal of the flipping regime. Using the proceeds from a cash-out sale of properties to acquire more foreclosure-related properties for quick resale at a profit is dealer conduct.
Even when properties are first held and operated as rentals for any period of time, the underlying objective is the same: the resale of a property at a price marked up for a margin. Even when they are rented out for over 12 months, the owner’s end strategy is to churn properties. This quick-sale activity is the hallmark of dealers, not income property investors placing their wealth in property for long-term rental income. [Little v. Commissioner of Internal Revenue (9th Cir. 1997) 106 F3d 1445]
Owners of dealer property held for any period of time and sold at a price exceeding its cost do not take a profit — gain — on the sale. Dealer property is inventory, a non-capital asset. When a developer sells a parcel (bought months or years earlier with the intent to resell it when the time is right), the developer is conducting a business and has received ordinary income, not a profit. The denial of capital gains (profit) treatment on the sale of a parcel of real estate held for sale to others is due to its qualification as dealer property.
Further, dealer property and other inventory items sold as merchandise in the conduct of a trade or business are excluded from being classified as §1031 like-kind property. [26 USC §1031(a)(2)(A)]
Likewise, dealer property is not afforded the deferred reporting of profit on installment sales under the standard income tax (SIT) and alternative minimum tax (AMT). Speculators, including developers, who retain title on the flip of a property to a buyer under a land sales contract, purchase lease-option sale or other masked security device installment sales transaction, receive ordinary income on the portion of the price received greater than the price they paid. This income is reported and taxed in the year of the transaction, with the exception of the deferral of ordinary income on the installment sale of:
- vacant residential lots; and
- short-term time shares. [26 USC §453(l)]
Conversely, taxes on profit taken from the sale of a capital asset are deferred to future years when any part of the price is paid in the years beyond the year of sale. It is an installment sale, no matter how it is documented. [26 USC §§453(b)(2)(A), 453(l)(1)]
A cash-out sale, devoid of a coordinated continued investment in §1031 replacement real estate, and the owner’s tell-tale property churning are red flags which trigger an IRS audit to determine dealer property status.
Dealer property vs. capital assets
Whether real estate is dealer property or a capital asset depends on the owner’s circumstances which exist during the entire period of ownership of the property, from the purchase to the ultimate resale.
The ownership of property by an individual is also distinguished from the ownership of property co-owned as a syndicated investment by two or more individuals or by an entity, such as a:
- limited liability company (LLC);
- limited partnership (LP); or
When the entity owns a property, it is the intention and conduct of the entity’s management during its ownership that is the factor used to determine whether it is to be treated as dealer property, such as land held fallow for investment without plans for immediate development.
The individuals to whom the entity distributes its earnings are not the owners of the real estate. Thus, their personal real estate activities are not attributable to the entity when establishing the intentions and conduct of the entity’s management of its real estate.
Consider an individual’s investment plans where properties held in the individual’s name are only those held for long-term investments in income property or land. The dealer properties are acquired in the name of an LLC or other entity so not to interfere with the ownerships vested in the name of the individual.
Ownership factors which distinguish dealer property from investment property include:
- the owner’s intentions when acquiring the property (to either take steps as a speculator to promptly cash out on its resale, or hold it for investment operated either as passive rental income property or as a management-free portfolio asset held for profit on an ultimate resale);
- the owner’s intentions manifested while owning and operating the property;
- duration of ownership before advertising or listing the property for sale;
- use of the property at the time of sale;
- the frequency, continuity and substance of the owner’s sales of other properties;
- the extent of advertising for buyers, listing the property for sale, other promotional sales activities;
- the extent of personal earnings from the sale of similar properties by the owner;
- the time and effort devoted to the sale of the property by the owner;
- the extent of subdividing, construction of improvements, planning, zoning efforts, arranging for utilities, rehabilitation/renovation, etc. for the property; and
- the nature and extent of the owner’s regular business as related to the sale of the property. [Matthews Commissioner of Internal Revenue (6th Cir. 1963) 315 F2d 101]
No single factor is conclusive. Rather, the factors are considered in concert to determine whether the dealer or investment property classification applies. Usually, the frequency and substantiality of the owner’s sales and the extent of the owner’s income from sales play the most dominant roles in making this distinction.
For an owner’s cashed-out sales activities, the greater the frequency of sales among all properties owned and the more the owner’s conduct demonstrates they intend to buy, build or renovate, and sell property for cash (regardless of an interim rental program), the more likely the real estate sold will be considered dealer property. [Little, supra]
Conversely, when an owner intends to buy, build or renovate, and maintain a continuing investment in real estate for an extended period of years, as a collectible in a long-term future income plan, the real estate is a capital asset. Its resale for cash after years of ownership qualifies the earnings on a sale to be reported as a profit, not ordinary income.
Again, the dealer property issue arises on a cash-out sale of the property, not when the proceeds from the sale are reinvested in a §1031 reinvestment plan. With a §1031 reinvestment, the owner’s intent is to acquire replacement property in a continuation of their real estate investment. Also, vesting in an LLC versus the individual’s name is another way to differentiate the ultimate intent of the owner.
Knowing these tax facts helps investors avoid the dreaded “dealer designation” and the negative tax consequences it entails. Although no fixed formula exists for determining whether a property is classified as dealer property or a capital asset, the facts and circumstances of each year’s sales transactions — along with the investor’s proper documentation of their long-term passive or portfolio income category activities — are critical.