Unfortunately, real estate investors are not all created equal in the eyes of the IRS. If you're an investor, there are four different types of real estate investor definitions that you will want to watch out for:
Real Estate Investor
Real Estate Dealer
Real Estate Professional
Real Estate Developer
For tax purposes: Two are good; two are not. And, like many things in life, being prepared for a bad thing might mean that you don't have a problem at all.
Real estate dealer
If you are considered a real estate dealer, you have a trade or business, not an investment. This means that you will have to pay self-employment tax of 15.3%, just like any other business. But what is potentially worse, you will also have lost the ability to take the installment method for tax.
This means that if you sell a property "over time" using any form of seller financing, you cannot pay tax on the gain as you receive payment. Instead, you have to pay ALL of the tax on the gain on the property immediately, even though you might not have received any money yet.
How does the IRS determine dealer status?
The IRS determines real estate dealer status based on the "intent" of the taxpayer holding or buying the property. The characterization of gain or loss on the sale or exchange of real property turns on whether the property was held "primarily" for sale or investment. The Courts have come up with their top fifteen items that they look for in determining the status:
Taxpayer's purpose for acquiring, holding and selling the property
Number, frequency and continuity of sales
Duration of ownership
Time and effort expended by the taxpayer in promoting sales
Taxpayer's use of brokers
Extent of improvements and subdivision made to facilitate sales
Ordinary business of the taxpayer
Extent and value of the taxpayer's real estate holdings
Extent and nature of the transactions involved
Amount of income from sales as compared with the taxpayer's other sources of income
Taxpayer's desire to liquidate landholdings unexpectedly obtained
Taxpayer's overall reluctance to sell the property
Amount of advertising
Use of a business office for sales
Taxpayer's control over any sales representatives
Of these, the most important issue appears to be the number, frequency, and continuity of sales. In other words: If you sell a lot of property, you might be considered a dealer simply because that appears to be the type of real estate "investing" you do. It is also possible to be treated as a dealer on one property and an investor on another.
In this case, the IRS will look at the taxpayer's intent with that particular property. For example, they will look for sales activities that show that property was held primarily for sale if they are attempting to prove dealer status. These activities would include advertising, "for sale" signs, a sales office, and employment of sales personnel.
Real estate dealer tax planning
If you are considered a real estate dealer, then the income you make will be subject to a self-employment tax. You might consider holding the real estate within a Limited Partnership (only the general partner would be subject to self-employment tax) or a corporate structure.
A real estate dealer is being treated as a business, so you need to plan for the appropriate business structure accordingly. If you have a concern that a portion of your real estate will be considered under "dealer status" and have no worries about another portion, a good strategy will be to have separate business structures for the two portions of your real estate portfolio. This will keep the issue contained.
The biggest problem occurs when you are deemed a real estate dealer and you carry back a note. If you are a dealer, you cannot defer your gain from the sale until you receive money. In this case, the best strategy is to be forearmed. Instead of doing an installment sale, consider doing a "rent-to-own" type of lease option program.
The difference between these two types of programs (installment sale and rent to own) is the constructive ownership. When does the sale occur? If it occurs later, after you are paid in full, then you have no problem with this particular tax issue. But you can't do this after the fact. The proper agreements must be set up ahead of time.
Real estate professional
One of the biggest benefits to investing in real estate is the ability to offset the real estate paper losses (primarily caused by depreciation) against your other income. If you can qualify as a real estate professional, then 100% of your paper real estate losses can be used to offset your other income.
Otherwise, this real estate paper loss is limited to $25,000 if your income is under $100,000. The $25,000 phases out as your income exceeds $100,000 and is completed disallowed by the time you reach $150,000. The loss doesn't actually go away. Instead, it is "suspended" to be allowed at the time that the property sells.
One way around the paper loss limitation is if you or your spouse (if filing jointly) can qualify as a real estate professional. The real estate professional status is based on hours that are performed in real estate functions. You must spend more time in real estate activities than in any other activity for which you are compensated.
[Read The Real Estate Professional Tax Loophole for more information on Real Estate Professional status, including Diane's "Test of Hours."]
However, if you are in a real estate activity type profession, such as a real estate agent, then you will qualify as long as you own 5% or more of the business that is paying you. Don't let this confuse you if you are a real estate agent. You are most likely paid as an independent contractor. That independent contractor income IS your business.
However, if you are paid as an employee of a real estate agency and do not own a minimum of 5% of the company, then you will not qualify under this provision. First, you will need to understand what real estate activities actually are. A qualified real estate activity is any thing in which you "develop, redevelop, construct, reconstruct, acquire, convert, rent, operate, manage, lease, or sell" real estate.
Remember that the key is that you perform personal services in these activities, but you don't necessarily have to be the one performing the work. You can be supervising, meeting, planning--all of the activities that go into truly running a business.
[For more detailed definitions of real estate activities, see Diane's article, The Real Estate Professional Tax Loophole.
In IRS Definitions for "Real Estate Investors" (Part Two), Diane will explain real estate developer status and related tax issues. She'll give us an exercise: "What Type of Real Estate Investor Are You?"]
About the Author:
Diane Kennedy, the preeminent tax strategist, is owner of Diane Kennedy & Associates, a leading tax strategy and accounting firm that works with clients throughout the US. Diane is the author of The Wall Street Journal and Business Week bestsellers, Loopholes of the Rich and Real Estate Loopholes and co-author of The Insiders Guide To Real Estate Investing Loopholes and The Insiders Guide to Making Money in Real Estate.
A highly sought-after international speaker and educator, Diane has dedicated her career to empowering and educating others about financial investments and the tax advantages that are available.
Through her knowledge and execution of tax loopholes in her business and real estate investments, she and her husband Richard are able to contribute to special life-changing projects and charities in the US and third-world countries.
Diane specializes in teaching investors how to use legal tax loopholes right now to reduce the amount of tax they pay while building their wealth. She offers several home study courses designed to educate and empower real estate investors in tax-advantaged wealth-building techniques.