When you get into “selling” scenarios (like wholesaling, retailing, options, lease options), the IRS (or your CPA) may try to classify you as a real estate “dealer.”
Being tagged as a “dealer” could be a financial disaster because unlike a real estate “investor,” you are subject to the highest ordinary income tax rates, plus self-employment taxes, and possibly alternative minimum taxes (AMT). Thus, 50% or 60% or even more of your hard earned profits could be drained by taxes.
Moreover, dealer profits (whether received by cash or by taking back paper) are immediately taxed in full and cannot be tax-deferred in any way, including not being able to use a 1031 exchange, installment sale reporting (seller financing), or a self-directed IRA.
Being tagged as a dealer could wipe you out! On the other hand, if you show your status as an investor, you can avoid these expensive pitfalls of being a dealer.
Totally Avoid Being a Dealer and Save Thousands
First off, based on numerous tax courts cases (including a Supreme Court case), actual IRS audits, and my own extensive research, even a very large number of sales in one year could avoid dealer status. In fact, there are over 30 strategies to avoid the costly consequences of a dealer.
My experience indicates that one of the best strategies is to demonstrate investment intent in that the primary purpose of the resale profits is for investment purposes and not sales speculation.
For example, the primary purpose (or purposes) of the profits can be for a number of “investment necessities,” such as down payment funds to acquire long-term investment keepers or working capital for investment property operations, including preventive maintenance.
Accordingly, as used here, these flips are non-dealer investment transactions with solid economic foundation.
This is a powerful defense against any IRS attacks. Consequently, there are numerous cases and scenarios, some of which I have had first-hand experience with, where even a huge number of sales in one year did not cause costly dealer status.
Real estate investors can bypass being a dealer by planning in advance with dealer-avoidance strategies (especially investment intent). Avoid inept advisers and go for it!
Case Study: Total Dealer Avoidance
Pat is one of my students. The previous tax year he just started to get into real estate and sold five (5) properties that first year. Pat’s tax preparer “tagged” him as a “dealer” and reported the property sales on IRS Schedule C.
This is the worst possible schedule because:
- It blatantly admits that he’s a dealer
- It increases his chances of an IRS audit quite a bit
- It incurs the highest tax liability, especially with “garbage” self-employment taxes
Fortunately, the return was not yet filed. An examination of the facts indicated that Pat should not be classified as a dealer.
The Goldmine Solution:
- Eliminate Schedule C and remove the property as “dealer property.” Instead, use an LLC-partnership. (Pat and his wife can be partners.)
- Hold the properties for rental and claim depreciation, even for short holding periods. (Investment intent strategies).
- Immediately fire the present tax preparer and engage a competent real estate tax specialist–or do their own taxes without a tax advisor. (No tax advisor is a lot better than a bad one!)
- In the future, follow the above dealer avoidance strategies, as well as the related audit-proofing strategies.
The Positive Results:
- We established Pat as a real estate “investor.”
- We substantially reduced his chances of being audited with no Schedule C.
- We saved him fees and poor advice by eliminating his idiot tax preparer.
- We substantially reduced his taxes by not having to pay self-employment taxes and lower capital gain rates if any of the properties are held for more than a year.
- Pat could zero out taxes on the sales with a 1031 tax-free exchange by being an “investor”.
These are brief excerpts from Al Aiello’s tax system: The Renaissance Goldmine Of Brilliant Tax Strategies for Real Estate Investors.