Are you an investor or a dealer? Read on to understand the differences between the two designations, and avoid a nasty surprise at tax time.

Nearly half of all real estate buyers in 2013 purchased their properties with the intent of eventually flipping them for a profit. Some may hold their properties as rentals for a year or two while waiting for prices to hit the sweet spot for a sale. For the lucky few who didn’t drastically overpay, they’ll sell, and pocket their profit. Or, so they think.

The surprise comes after filing their income tax return for the year they sold, when they discover they are not considered an investor by the Internal Revenue Service (IRS), but a dealer.

Most real estate investors are aware of the advantages of the “investor” designation on their tax return.  But most are unaware of the potentially negative consequences of being declared a dealer by the IRS.

Considerable tax reporting differences distinguish dealer property from investor property, when sold.  An investor’s profits on the sale of their properties are taxed at the lower capital gains rate for capital assets owned at least one year. In contrast, a dealer’s earnings on sales of their properties are taxed as business inventory at ordinary income rates. These rates are much higher, regardless the length of time the properties are owned.

However, a dealer may own investment property and dealer property at the same time. Managing ownership of both dealer and investor properties makes it more difficult to prove that the sale of an “investment property” is subject to capital gains as a capital asset, rather than ordinary income on the sale of inventory in a buy-sell business.

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 (passive income category); or
  • held as management-free investments for income or profit (portfolio income category).

In addition, properties in both passive and portfolio income categories are also classified as §1031 investment properties. [Internal Revenue Code §1221(a)(1)]

The §1031 profit tax exemption also includes real estate used as a trade or business asset, 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 more than one year.

The only distinctions between §1031 business and §1031 investment property are:

  • the business use of the property; and
  • a one-year holding period imposed on business property prior to sale or exchange.

On the other hand, real estate held by an owner primarily as inventory for sale to customers in the ordinary course of the owner’s trade or business is an ordinary income asset, more commonly called dealer property. [IRC §§64, 1231(b)(1)(A), 1231(b)(1)(B)]

An ordinary income asset typically includes inventories purchased and then actively sold. This is construed as a business activity, not a passive rental activity or an inactive portfolio holding. Inventory includes:

  • developable or subdivisible 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 by 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. Using the proceeds from a cash-out sale of other properties to acquire more foreclosure-related properties for resale is dealer conduct. Even if the properties are first held and operated as rentals for over 12 months, the underlying result is the same: they are churning properties. That activity is the hallmark of dealers, not income property investors. [Little v. Commissioner of Internal Revenue (9th Cir. 1997) 106 F3d 1445]

Owners of dealer property 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 with the intent to resell 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 customers is due to its qualification as dealer property.

Worse, dealer property and other inventory items sold as merchandise in a trade or business are excluded from being classified as §1031 like-kind property. [IRC §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 transaction, receive ordinary income. This income is to be reported and will be taxed in the year of the transaction, with the exception of the deferral of ordinary income on the installment sale of:

  • farms;
  • vacant residential lots; and
  • short-term time shares. [IRC §453(l)]

Conversely, taxes on a profit taken on the sale of a capital asset are deferred to future years when any part of the price is paid in years beyond the year of sale.  It is an installment sale, no matter how it is documented: trust deed note or otherwise. [IRC §§453(b)(2)(A), 453(l)(1)]

A cash-out sale, devoid of a coordinated continued investment in 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 circumstances existing during the entire period of ownership of the property, from the purchase to the ultimate resale.

The ownership of property by an individual must also be distinguished from the ownership of property by an entity such as a limited liability company (LLC), limited partnership or corporation, co-owned as a syndicated investment by two or more individuals. When the entity is the owner of a property, such as land held fallow for investment, it is the intention and conduct of the entity’s management during its ownership that is tested against the factors used to determine dealer property.

The individuals who receive distributions of the entity’s earnings are not the owners of the real estate. Thus, their personal dealer activities (or its dealer activities) are unrelated to the entity’s ownership of the land and are not an issue when establishing the intentions and conduct of the entity’s management. 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.

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 either as passive rental income property or for ultimate resale as a portfolio asset at a profit);
  • 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 v. Commissioner of Internal Revenue (6th Cir. 1963) 315 F2d 101]

No single factor is conclusive. Usually, the frequency and substantiality of the owner’s sales and the extent of the owner’s income from sales play the most important roles.

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 that they intend to buy, build or renovate, and sell property for cash (in spite 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 a few 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 intent is to acquire replacement property in a continuation of the owner’s investment in like-kind real estate. Also again, vesting in an LLC or in the individual’s name is another way to differentiate.

Knowing these tax facts helps investors avoid the dreaded “dealer designation”. 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 documentation of their long-term passive or portfolio income category activities, are critical.