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IRS Definitions for "Real Estate Investors" (Part Two)

by Diane Kennedy, CPA   

[In IRS Definitions for "Real Estate Investors" (Part One), Diane defined real estate dealer status and real estate professional status and the related tax planning. In Part Two, she'll discuss real estate developer status and related tax issues.]

Real estate developer tax issues

Another issue for novice real estate investors to be aware of occurs when they develop property. Say, for example, you find a great piece of land and decide to develop and subdivide it. This true story demonstrates the problems of suddenly discovering that you are a real estate developer.

Real Estate Developer by Mistake

Bob and Ruth found twenty acres with zoning that could easily be changed into that of a mobile home park. The twenty acres could be turned into sixty spaces that would rent quickly for an average rent of $200 per month. That meant a gross income of $12,000 per month.

There would be some maintenance, landscaping, and management costs. At the very high end these costs would be $3,000 per month. One of the spaces would be provided to an on-site manager, reducing the gross income by $200. They were looking at potential income of:

Gross rent: $11,800
Vacancy costs: ($1,800)
Maintenance costs: ($3,000)
Monthly gross: $7,000

The cost of the property was $200,000, and the owner would carry a note at 8% with 20% down. They estimated the improvements would cost $10,000/space, and they got tentative approval for a construction loan with 30% down. They had the necessary $40,000 for the down payment for the purchase and could liquidate some resources to get the $180,000 they needed for the construction loan.

They had always heard that real estate provided "paper" losses that could offset their other income, and so they didn't worry about the tax consequences of selling their stock. After all, they reasoned, they were spending the money on another business venture.

At tax time though, they discovered the tax truth of what they had done. The land was not depreciable. That meant that the $200,000 ($40,000 of it in cash) was all booked as an asset with no expense to offset it. The construction was considered as a land improvement and would be expensed or depreciated once it was completed.

So, at the end of the first tax year, they were 75% completed with the project. They had liquidated stock, which incurred capital gains tax, and had drained all of their resources to develop the property. They had spent $220,000, and none of it could be a write- off. Bob and Ruth were developers, much like someone building an apartment house, and none of their investment would be depreciated until it was put into service.

Additionally, Bob and Ruth discovered that the interest from the land note and the construction project was capitalized with the asset. It was not currently deductible and would instead be amortized and expensed over time. The money was flowing out, they were investing in a business, and none of it was deductible--yet. They had a horrible tax surprise the first year.

The key to determining whether you are a developer is whether you must perform work to put the property into service. The development might be subdivision, land improvement, or even rehabbing a property. You would be treated as a developer during the time you held the property before it was put in service. During this time you would not be able to take the depreciation deduction.

One more issue for some real estate developers is Uniform Capitalization rules. This is a very complicated and little understood area of tax law. In fact, many tax practitioners are unfamiliar with it. Here is another true story on how the Uniform Capitalization rules (which force you to capitalize a portion of certain expenses) can creep up on you.

Developer? Who, me?

Tom and Cecilia had a successful real estate investment and property management enterprise. They had a staff of four people who helped them with the ongoing maintenance and bookkeeping for their investments. They wanted to keep growing their business, but had reached a point where they simply couldn't find the deals on more real estate investments.

So, they decided to build new properties. Tom had a contractor's license and they already had the beginning of a staff to work with the sub-contractors he needed. They bought their first parcel and began construction on a large, multi-unit apartment house.

At tax time, though, they discovered that they couldn't take a deduction for any of the payments on the land, the down payment, or the out-of-pocket expenses for construction. But, even worse, a large portion of the administrative expenses and salaries for their employees were now no longer deductible.

The construction of the apartment building made Tom and Cecilia subject to Uniform Capitalization on all of their administrative expenses, even those that used to be deductible through the rest of their real estate investment business.

Here is a form that we use at DKA (our CPA firm) to determine the real estate status for clients:

What type of real estate investor are you?

This questionnaire should be completed for each individual property. The status (real estate dealer/developer/investor) is determined on a property-by-property level. Generally, you want the investor status on property as it avoids the self-employment tax and accelerates tax due on properties sold with a note of the dealer and the Uniform Capitalization requirements of the developer.

1a. What was the intent when the property was purchased?

If the answer is that it was to be rented or otherwise held as a long-term investment, then ask the follow up question below; otherwise go to 2.

1b. How long was the property held before it was sold?

  • If property is still owned or was held for at least a year prior to sale, this will generally qualify as a real estate investment. Go on to the next property.

  • If the property is to be extensively rehabilitated, demolished, or developed prior to use or sale, go to 3 below.

  • If the property was sold (even if that sale was done with a land sale contract, seller financing, or other form of carried back note) after being held less than one year, go to 2 below.

2. If the property was sold within one year, do you have evidence that the sale was a result of a change of plans?

A change of plans means that the owner started out with one intent, then changed. Typically, you want to show proof that an early sale was a change of plans; otherwise, you will have real estate dealer status.

A change of plans could be shown as a result of other financial issues of the owner--change in marital status, move, change in income or other expenses-- or as a result of unsuccessfully trying to rent it. If you can show evidence that the sale was done as a result of a change of plans, this property qualifies as a real estate investment.

Note that the gain would be subject to the short-term capital gains rate, not the long-term capital gains rate. Go on to the next property.

If the property is shown to have been sold with the initial intent at the time of purchase to sell, then the property will qualify under the dealer status. Go on to the next property.

3. If the property was purchased with the intent of extensive remodeling or rehabilitation, was the property first put into service as a real estate investment property?

If the property was initially rented for the same purpose as the ultimate use, such as by renting half of the units in an apartment building while you extensively remodel the other half, then you have an investment property with remodeling costs.

The property should be depreciated and the current expenses, such as mortgage interest and property tax can be expensed. Go to the next property.

If the property had a use that wasn't the same as the development purpose, such as the rental as pasture for part of the land while a trailer park was being built, the property might still be subject to Uniform Capitalization. Review the magnitude of the development costs in relationship to the rental of the property and determine reasonableness of status. Go to the next property.

If the property was bought solely to be renovated, this property will be a developer property. Go to the next property. As you can see, real estate investing has its own terminology. The better you understand the terms, the better you can communicate with your bookkeeper and CPA.

There are some key questions your advisors will need to know such as when the purchase actually occurred, what the basis was, when a sale occurred, and how to account for the income and expense in between. Real estate investing might have gotten more creative, but the same basics of accounting, record keeping, and tax still apply.

About the Author:

diane kennedyDiane 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.

 
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