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Lane
Lane, CFP, MBA, CRPS
Category: Tax
Satisfied Customers: 3644
Experience:  Providing Financial & Tax advice since 1986
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How do you avoid being considered a Real State Dealer by the

Customer Question

How do you avoid being considered a Real State Dealer by the I.R.S.? Do you need a certain type of entity to do quick flips of residential properties?
Submitted: 12 months ago.
Category: Tax
Expert:  Lane replied 12 months ago.

NPVAdvisor :

Hi,

NPVAdvisor :

If you just want to buy the properties and then sell them for a profit, (and not get the licensing to be an agent and sccept commissions) this is no problem

NPVAdvisor :

Real estate agents have to be licensed by the real estate board in your state, and this qualifies them to accept commissions for the sale, (an listing as the buyers agent as well), on real estate sales

NPVAdvisor :

Some will get the licenses so that they aren't paying commissions out to others, thereby increasing profits

NPVAdvisor :

Some only deal with buyers who use FSBO (For sale by owner) title companies and avoid the commissions that way

NPVAdvisor :

YOu don't have to be an agent or realtor to simply invest in a property and the sell it for a profit

Customer :

I want to do this as an investor not an agent, I have been informed that if you do this as an individual and you are flipping over 5(?) properties, the I.R.S. can consider you as a dealer thus losing many tax benefits.

NPVAdvisor :

Ahhh what I think you may be talking about here is the 25,000 loss allowance

NPVAdvisor :

The ability to deduct your rental property losses against your ordinary incomes actually requires that you DO participate in our business of buying, renting, etc.

NPVAdvisor :

This boost in profits is what lawmakers had in mind when they enacted the $25, 000 active participation rental property loss allowance as a special favor for rental property owners who qualify.


You qualify for the full allowance of up to $25, 000 in rental property loss deductions if




    • you actively participate in the rental, and



 



  • your modified adjusted gross income is $100, 000 or less.

NPVAdvisor :

If you don't qualify for this, then your capital losses can only be used against capital gains you may have, as opposed to any other type of earned, ordinary, income

NPVAdvisor :

The $25,000 tax-favor allowance applies to rental real estate. It does not apply to other rentals such as equipment leases.

Customer :

no, are you aware fo what constitutes a "real estate dealer" as defined by the I.R.S ?

NPVAdvisor :

My apologies, most here are asking about the passive loss limitations ...

NPVAdvisor :

yes - The IRS will, at their discretion, determine if a taxpayer is a dealer. Once they make that call the taxpayer will then be paying ordinary income tax rates instead of the much lower long term capital gains rates.

NPVAdvisor :

You see, investors are long term while dealers are more the get in, get out ASAP variety. The IRS doesn’t want dealers to benefit from the much lower long term capital gains tax rate. In many cases it’s less than half the taxes of what a dealer would pay.

NPVAdvisor :

Internal Revenue Code § 1221 says a capital asset is, (in part) “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

NPVAdvisor :

What that means to you is simple — if the property you buy is meant for your ‘trade or business’ and not for investment, you’re gonna be designated as a dealer — at least as far as that particular property is concerned. Your tax rate is then automatically derived from ordinary income tax rates which will almost always be double (usually more than double) the long term capital gains rate.

NPVAdvisor :

IRS will VERY quickly tell you that rules of thimb like 5 properties in so long a time will not hold water.... they look at each and every transaction on it's own merits if they decide to audit you

NPVAdvisor :

How long you hold the property and how many properties you’ve been selling lately is what they want to know. The longer you hold the better you look.

Customer :

Good, then can you tell me what Corp. structure can I create so this will not be a problem? LLC vs C-corp?

NPVAdvisor :

Just a couple mor points here, ... might help you see around some corners....

NPVAdvisor :

If you’ve been buying and selling properties like a dealer, then sell one 14 months after buying it, they’re gonna call you a dealer. At that point you’re treated as guilty until you or your CPA or tax attorney prove you innocent

NPVAdvisor :

ONe last thing ....

NPVAdvisor :

The courts don’t make it any clearer either. They add their own brands of mud. Each court decision is yet another layer — and that doesn’t count the courts of appeal ... and finally ... Another factor is what you do with the property. rezone it? Make massive improvements meant to significantly improve value? Or God forbid, subdivide it?

NPVAdvisor :

And for the record? Real estate investors nearly always do far better over the long haul, (and usually the short haul too) than dealers.

NPVAdvisor :

Ok that's the extent of my wisdom there

NPVAdvisor :

On the entity

NPVAdvisor :

S-corps, LLC's and C-Corps are separate entities, they separate your personal assets from the business assets (fo the purposes of collectors, lawsuits and any other sort of liabiity

NPVAdvisor :

On the tax front? C-Corps and irrevocable trusts are the only ones that pay taxes themselves, at separate rates ... LLCs S-corps partnerships and sole proprietorships all pass the tax losses and profits to the individual taxpayer on line 12 of the return (business income or loss)

NPVAdvisor :

C-Corp? ... double taxation ... Once the C-corp has paid it's own taxes, then the owners are taxed again on the profits as dividends

NPVAdvisor :

S-corp is probably a better pass through than an LLC because you don't pay self employment tax on the excess profits over and above your salary ... LLC's partnerships sole proprietorships ALL pay self employment taxes on ALL profits

Customer :

again yes, I know about the various entities and their tax ramifications, which one protects me from being considered a real estate dealer is my question.

NPVAdvisor :

The corporate structure has nothing to do with the distinction between being a dealer and an investor with one EXCEPTION... a C-corp doesn't have capital gains ... it's all income at whatever your corporate rate is (and again, then taxed to you personally if you want to pull money out as dividends)

NPVAdvisor :

So, in effect, the answer to your question is that there isn't one. It's not that simple ...C-corps don't get that capital gain treatment you're looking for and all the others are pass throughs, hence, the distinction can't be avoided by virtue of your entity choice

Customer :

thanks

NPVAdvisor :

Sorry, don't shoot the messenger

Lane, CFP, MBA, CRPS
Category: Tax
Satisfied Customers: 3644
Experience: Providing Financial & Tax advice since 1986
Lane and 7 other Tax Specialists are ready to help you
Expert:  Lane replied 12 months ago.

Thanks for the rating Gil.

Hopefully having all the facts will help you see around some corners.

I'll offer up my advice (and I can document this empirical research):

Real Estate Investors do better, when you measure the results over any decently ling period of time that dealers do, anyway.

The stories aren't as glamorous, and it's not IMMEDIATE gratification, but if you buy properties, add value, drive income from them, take the depreciation and maintenance deductions, and then sell for gains a few years down the road....

... Your overall return over that time period of several years will, in my experience, be better and provide more options over time. (1035 exchanges, etc)

Best of luck,
Lane
Expert:  Anne replied 12 months ago.

Hi

 

Different expert here

 

You asked for specific information that the IRS would use to judge whether or not you have an investment property or if you could be considered as a professional realtor.While there is no magic formula, the IRS does look at these:

 

Flipper / Dealer or Real Estate Investor - The Tests

 

The most important factors used to make this call are the INTENT and PURPOSE of the property acquisition and holding. Some of the criteria used by the IRS and the courts to determine intent and purpose include:

 

Length of time the property is held - Normally an asset needs to be held for over one year to qualify for capital gains treatment. This is true of real estate, but this is not a definitive test. Just because property is held for over one year does not necessarily make it investment property.

 

Number of properties sold in a year – There is no set number, but if you sell only one property in a year, you are probably NOT a dealer.

 

Have a job outside of real estate? – If your primary job is not related to real estate, you are probably engaged in real estate investing.

 

If you are a real estate broker, real estate developer or associated with a real estate company, you are likely to be considered a flipper / dealer.

 

Have employees who help you sell the properties? – If you have employees who help you sell real estate, you are likely to be a flipper / dealer. Use a business office to sell properties? – If you sell properties out of a business office, you are most likely a flipper / dealer.

 

 

I truly hope this information is helpful but please do not rate until you are satisfied. If you want to click on 1 or 2 just click on the continue to work with me button instead. You will then be able to add any other info or respond to what I have posted so far. Rating 3-5 gives me credit and a good rating but you can still converse with me.

Expert:  Lane replied 12 months ago.

Hi Gil,

You originally rated my answer as OK.

Then a second expert added some information (saying essentially the same thing, along with SOME additional info).

Now I've noticed that you've come back and rated my response from right after we talked yesterday as bad service.

Was that meant for me?

Regardless, my goal here is to make you a satisfied customer.
Not only that, a bad ratings affects my ratings AND my pay here.

I spent some time this morning doing some additional research to see if I could find a botXXXXX XXXXXne for you and I've found some additional information that should bet be useful. ...


... the definitive answer:

There has been both ...

(1) a Supreme courtt ruling AND

(2)a Tax court ruling




The SUPREME COURT defined primarily as meaning “of first importance”.

"How one determines the purpose of the property sold as a dominant part of taxpayers’ course of business is a matter of facts and circumstance.

When real estate developers buy and sell property as part of the ordinary course of a “trade or business”, they are considered dealers not investors. If considered a dealer, then the taxpayer will not be permitted capital gain treatment on the sale of such property."




The TAX COURT considered the following factors in determining whether property is held as part of the ordinary course of “trade or business”:

  • The purpose for which the property was acquired.
  • The purpose for which it was held.
  • Improvements, and their extent, made to the property by the taxpayer.
  • Frequency, number and continuity of sales.
  • The extent and substantiality of the transactions.
  • The nature and extent of the taxpayer’s business.
  • The extent of advertising to promote sales (or lack of advertising).
  • The listing of the property for sale directly or through brokers.
  • The above factors are applied to each specific property sold and in question, rather than the activities of the taxpayer.


These activities will support that the taxpayer is an investor (rather than a dealer), therefore allowing the tax benefit, capital gain treatment on the sale of property):

Income Test: The amount of gain created by a real estate transaction versus the income from an individual’s daily activities

Activities Test: Were measures taken to plot, subdivide, or improve the properties. Minor investment activities acceptable.Sale of the property is not due solely to the improvements to the property.Market factors vs. property improvements play a large part to the disposition of the property

Sales Solicitation Test: Properties are not advertised for sale; nor are “for sale signs” placed on the properties or brokers used to sell properties. Sales are the result of a purchaser’s initiation.

Sales Frequency Test: The number of properties sold within a given time period. The Tax Court determine nine properties in four years did not constitute a business.

Continuity Test: Engagement in a business requires “regular and sustained” versus “intermittent and occasional activities”.

Time Test: The normal working time spent on career activities is greater than the amount of time spent on real estate transactions.

Facilities Test: The taxpayer does not maintain a separate office to transact real estate activities. In addition the taxpayer is not a licensed real estate broker or associated with a real estate company.

With the bulk of the above tests documented the taxpayer can qualify as an “investor”.






Change of circumstances can also dictate whether a property was held for investment or whether the property is held as inventory for sale. Proof in the change of circumstances and intention can determine the success of changing a property from “dealer” property to “investor” property. In one case, the intention of the taxpayer to develop land to residential builders was changed by the state in its determination that the land was condemned and could not be developed. The taxpayer then changed the plans for the land and when the property was sold the gain was taxed at capital gain rates.

One of the more frequent causes of change in circumstance is due to unforeseen financial trouble. In a court case, the financial difficulties of the land development corporation, prompted creditors to place restrictions on the company’s activities. The creditors strongly recommended that the company leave the development business and sell the land without solicitation. The court determined that the property concluded its intention of being held for sale to the public in the ordinary course of business. The result of gain from the land sale was not due to the owners’ development or promotion but due to the elapse of time and natural amassing.

Conclusion: There is no fixed formula to determine whether a property is held for development or investment. The facts and circumstances of each transaction and the documentation of the taxpayer’s activities are critical. ... but maybe this gives you more detail, and what the supreme court and the tax court have actually laid down, for you to use to build a case of investor vs dealer.



Hope this helps...

Lane

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