A common question that arises as a new real estate investor is what classification you fall under in the eyes of the internal revenue service (IRS) -- a real estate dealer or a real estate investor? There are major distinctions between the two, and ultimately what category you fall under will determine what tax rate you fall under as a taxpayer, whether you are subject to self-employment tax, and how your real estate investments are taxed.
Learn the difference between a real estate dealer and a real estate investor and the tax implications of being a dealer versus an investor.
What is a real estate dealer?
A real estate dealer is a person who is in the business of owning real estate for the main purposes of reselling, not for long-term investment purposes. This could include real estate investors or real estate professionals who buy, build, or sell real estate as their primary business. Some examples of real estate dealers are:
- Rehabbers who fix and flip properties.
- Real estate developers who build subdivisions or real estate property for the purpose of selling.
- Wholesalers who assign contracts to end buyers.
- Land investors who buy and flip vacant land.
While these are clear examples of real estate dealers, the tax classification is actually determined not necessarily by what you do but by the following factors combined:
- Frequency of sales and number of sales.
- The original intent when buying the investment property.
- Duration of ownership.
- Extent of improvements.
- The effort involved in the sale of the property.
- The amount of income generated from the investment compared to other income sources.
- The amount of participation during ownership.
- Whether offices or business space were held during the time of ownership or sale of property.
Someone who is in the business of buying and selling real estate and does so in large quantities in a given year or period of time will almost always be classified as a dealer. However, certain factors can change over time.
For example, if you are a chiropractor who runs a practice for your primary income but also owns commercial property, renting out the additional office space, you may not be considered a dealer, even if the property was held for a short period of time.
Your intent of purchasing the real estate matters, as does what it's used for and how active you are in managing and selling it. In our chiropractor example, if you spent a significant amount of time meeting tenants for the additional office space, writing leases, collecting rent, and coordinating repairs during the period of ownership, then you could be considered a dealer in that case, because the investment would no longer be passive.
Real estate dealers are not specifically defined by the IRS, meaning the definition is open for interpretation by the prevailing court.
What is a real estate investor?
A real estate investor is someone who buys real estate for investment purposes, with the intention of holding the asset for long-term return on investment. Examples of real estate investors include:
- An individual who owns rental real estate utilizing third-party management for the day-to-day operations of the properties.
- An individual registered as a limited liability company (LLC) who owns commercial real estate, like an apartment complex or self-storage facility, holds the property for investment purposes (typically several years), and has very little active role in the day-to-day management of the property.
- An individual who sold their primary residence in an installment sale and is now collecting income from the mortgage note.
Again, these instances are obvious examples of who would be classified as a real estate investor, but the internal revenue code does not necessarily have a clear definition between the two. There are many more scenarios where someone could qualify as a real estate investor beyond the examples above.
Tax implications of being a real estate dealer vs. and investor
The main reason people strive to stay a real estate investor rather than a real estate dealer is because of the tax implications. Real estate investors are taxed much more favorably than dealers and receive several tax benefits, including:
- The depreciation of a capital asset (the investment property).
- Tax deductions on real estate investment-related expenses.
- The opportunity for tax-deferred exchanges, called 1031 exchanges.
- Selling properties on installment sales.
- Favorable tax rates on the sale of properties held over a year (long-term capital gains tax, which is around 15% to 20%).
- Opportunity to offset passive income with passive losses.
Properties held by a dealer are not seen as a capital asset; therefore, dealers are not able to depreciate the asset. Additionally, the gains made from real estate transactions are taxed as ordinary income, which is subject to higher income tax rates than long-term capital gains (up to 39%).
This means the dealer may be subject to self-employment tax (FICA tax), in addition to paying ordinary taxes on their profits as long as the property is not held in an entity such as an LLC. Dealers do have one positive tax advantage, which is that their gains are considered ordinary, meaning they can use any losses to offset the gains.
The bottom line
As you can see, this classification can make a big difference in your overall tax liability as a taxpayer. While being a real estate investor is favorable from a tax perspective, there is nothing wrong with being a real estate dealer.
And you don't always have to be just one or the other. A number of real estate professionals have some real estate transactions that would be taxed as a dealer and others that would be taxed as investments. Knowing how to tax each investment individually is important and one of the reasons working with an experienced real estate accountant can be helpful when it comes to filing taxes for your real estate transactions.
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