Did you know that there is a distinct difference between a real estate dealer and a real estate investor in the United States?
If you’re flipping houses or buying rental properties or even collaborating on a development project, anyone that invests money in the real estate industry will fall in one of these two categories.
These are two distinct tax classifications offered by the IRS. Whichever category you’re in will have a major impact on the amount you have to pay taxes on every real estate transaction you make.
What is the difference between them and what role does taxation play in?
Real Estate Dealer Vs. Real Estate Investor:What They Do
A real estate dealer frequently purchases and sells real property “in the ordinary course of their trade or business.”
What does this actually mean? A few typical instances of dealers include:
- House flippers who purchase houses, renovate them and then sell them at a higher price in order to earn profit.
- Real estate developers who buy land, create subdivisions, and then resell the land.
- Wholesalers of real estate who buy properties and then sell them swiftly without any modifications or additions on the property.
- Land investors, with no other income sources, purchase land at an affordable price, and then sell it quickly at a higher price, either without any modifications or improvements in the area.
- Any real estate deal where the properties are treated as inventory that frequently cycles between balance sheets.
A real estate investor invests in property with the intention to hold it for a long-term buy-and-hold investment. Examples of a real estate investor are:
- A person who purchases an investment property to rent.
- Any entity that buys an apartment and rents out the units to different tenants.
- A park owner of mobile homes who purchases land or mobile homes, and leases them to inhabitants of the park.
- The owner of a storage facility rents out storage units in individual units.
- Any property that is bought for the purpose of generating a continuous revenue stream from rental.
In the same way, a real estate broker buys and then sells real estate to earn profits, while an investor purchases land and holds it in order to earn cash flow.
Why The Difference Matters: Taxes
A common person (especially those who don’t have to deal with property) will not be a problem however, the IRS isn’t so sure. It’s the difference between them that is significant because the tax one pays differs in comparison to the other.
When you contrast the tax burden of a real estate dealer to an investor in real estate, the tax treatment for a dealer is as a person who runs a business which buys as well as sells its inventory.
An investor is taxed just like a passive investment who earns a regular, long-term income from their investments.
Here’s a more thorough analysis of the reasoning of this taxation principle.
Real Estate Dealer
Since dealers treat their property as inventory, they’re as such subject to the same taxes that businesses of all sizes must be required to pay (like self-employment tax as well as temporary capital gains). That means that dealers will have to pay more taxes than an investor.
Furthermore, when a dealer sells an asset through or through an installment deal, they’ll be required to pay taxes on the proceeds from the sale right away in the initial year, not in the course of time until payment is collected.
There is a minor exception to certain kinds of land sale for residential use. For any other kind of installment sale in real estate tax obligations, they are due immediately the initial year. This discourages a lot of sellers who are selling their homes using owner financing.
Real Estate Investor
However, investors have an advantage in tax situations due to certain factors.
- If they decide to sell their homes, they pay a lower capital gains tax on their capital gains due to the fact that they keep them for longer.
- They aren’t exempt from the self-employment tax that is imposed on real estate dealers.
- They pay tax on their installment sale profits as the money is received and not in the initial year.
Remember that real property investors who own rental properties are able to write off depreciation as an enormous tax benefit that dealers in real estate don’t enjoy. The reason for this is because dealer’s properties are considered inventory and are not considered long-term cash-flow-generating rental properties.
How Does the IRS Distinguish Between the Two?
Technically speaking, the IRS does not define precisely what an “real estate dealer” is. That means that there’s several different ways to define the term “dealer” and the definition itself is subject to interpretation by the prevailing court.
According to the IRS, “correct answer” on whether the real estate transaction was done under a dealer or an investor status is dependent on a variety of variables:
- The reason for the purchase.
- The original intention of the buyer.
- What enhancements (if they were) were made and in what amount?
- The frequency and the number of sales the investor completed.
- The amount of revenue generated from the property is compared to different sources of earnings.
- The nature of business of the taxpayer.
- The amount of advertising was used to increase the sale of each property.
- If the property was purchased directly or through a broker.
- How long the property was held prior to being resold.
Generally speaking, if you’re selling or buying real estate and perform it in large numbers during a particular year it is likely that you’ll be considered a dealer.
However, the IRS has the power to and will decide whether you’re an investor in real estate or a dealer. If they don’t agree with your conclusion and have the power to rule against your decision.
However, this doesn’t mean that the tax system is negative for real estate dealers. Dealers have one advantage in taxation: The gains they make are considered “ordinary,” which means they can apply any losses to make up for their gains.
The distinction between a person as a dealer or an investor has a significant impact on the amount of taxes that a person needs to pay. You can imagine that the majority of people will try to stay clear of being classified as an investor or dealer.
Is There Any Way You Can Change Your Status?
It is interesting to note that this distinction often is more about an individual’s intentions rather than what ends up occurring for each property.
In this case, for instance, a person might purchase a rental home with the intention of holding for a long time, but decide to sell it earlier because of unforeseen reasons. Based on the circumstances and the results of the above-described criteria, the person could still be regarded as an investor based on the nature of the original intention.
Also, it is possible to find an owner who kept their properties for a long time or longer than expected. However, since their initial goal is to market their properties fast and quickly, they’d be considered dealers in the majority of cases regardless of whether the property has been converted into a long-term investment.
One taxpayer could be simultaneously an investor and dealer at the same time. In the IRS Code, each property is assessed separately. This means that a real estate investor could possess several rental properties, where they’re considered to be an investor and a dealer in a different property that they purchased and later flipped.
Thus, that “investor” or “dealer” label doesn’t have to be used for everything they have. The distinction can be applied to each property, based on the purpose they had at the time they purchased the property.
How Can You Prove Your Intent as an Investor?
Because your intention plays a significant role in determining whether you are an investor instead of a dealer, what can you do to strengthen your case to the IRS?
What boxes should you look over to make sure you have the best argument to be labeled as an investor?
It is important to know that the real estate investor is likely to invest in properties for rent income and capital appreciation and the profits they earn are usually regarded as capital gains, and often have a lower tax rate. Dealers, however, are people who purchase and sell properties as part of their daily business, with the profits being considered normal earnings and subject to tax on self-employment.
If you’re trying to demonstrate that you are an investor, not a dealer, you should consider these steps:
1. Long-Term Holdings: Typically, investors have properties to hold for longer periods (over one year) however, dealers can sell properties fast if you hold onto your property as well as renting it to earn income, you are able to show that you purchased it to invest in.
2. Reason for Purchase: Write down the reasons behind the purchase. If the purchase is in order to increase capital or earn rental income, then you’re likely an investor. If you’re purchasing to sell quickly to make profits, you’re acting more as dealers.
3. In terms of number of transactions: investors generally have less transactions annually than dealers. If you’re executing a significant amount of transactions every year, it could appear that you’re operating a trade or business, which suggests you’re a dealer and not an investor. It is possible to counter this impression by creating an independent entity for a small amount of investments over the long term, or even a separate entity that is solely created to own one property.
4. The purpose and nature of the Purchase: The way in which you promote and sell the property will also impact the way you classify it. If you list the property for sale on the day following the purchase that would be a part of the perception that you’re a dealer. However, if you keep the property for one year or more than two calendar years, it will prove the fact that you’re an investor.
5. Improvement and development: excessive significant improvements could indicate dealer status since it suggests an active attempt to market. Investors typically do improvements to boost the value of rental. If you are planning to make improvements to your property, you should think about, “What improvements would allow me to increase my rent revenue from this property?”
6. Earnings: In the event that a substantial portion of your earnings comes from the quick purchasing and selling of properties, then you could be classified as a dealer. Investors usually earn money from capital appreciation and rent.
7. Separate entities for different activities: If you’re a dealer and an investor, it is best to keep these two activities distinct. Make separate legal entities to handle your investor and dealer business and maintain a clear distinction between the two entities.
8. Keeping record: of your intention to purchase the property prior to the purchase. Keep a meticulous record of the transaction. This will be helpful if there is a requirement to defend your position in the future as an investor. For instance, you can send the CPA or broker with a time stamped email explaining that you plan to acquire the property for a long-term investment. Save the email and keep the records to serve to prove your initial motive behind purchasing the property.
9. The Legal and Financial Advisor: A financial or legal estate lawyer or accountant can give advice and ensure that you adhere to the right steps to determine your intentions as an investor in real estate.
Remember that these are only suggestions. The IRS will look at the facts and specifics of every instance. It is a good idea to talk to the experts at Parr & Ibarra, a certified public accountant in Keller, Texas who specializes in taxation of real estate for a personalized recommendation. Contact us now!
