Most commercial real estate professionals haven’t given much thought to whether they’re a dealer or investor, however the distinction can have a big impact on your bottom line. Real estate “investors” enjoy several tax advantages that are not available to real estate dealers. The most notable advantage is the benefit of realizing gains on sales held more than 12 months at capital gains rates. Conversely, property held by dealers is not a capital asset so dealers must treat gains as ordinary income resulting in a higher tax bracket & potentially self employment tax. Investors are not required to pay self employment tax on gains.
Two other noted benefits of the investor label include ability to use Section 1031 (like-kind) exchanges as well as installment sale transactions that allow for the deferral of taxes.
Though there are some drawbacks to dealer status, it’s not all bad news. Dealer losses are considered “ordinary” losses. This means dealers aren’t subject to the restrictions that limit the amount of capital losses a taxpayer can offset against ordinary income to reduce their tax liability.
Dealers are also allowed to deduct their full interest income expense on property from their ordinary income; an investor can’t claim an interest expense deduction greater than the amount of its net investment income. Finally, dealers can offer “rent to own” lease programs, in lieu of installment sales as a way to defer recognizing gains.
IRS Distinctions between Dealer & Investor
The IRS typically distinguishes an investor from a dealer several ways. Most simply investors typically hold properties with a long term perspective. Dealers purchase and sell properties relatively quickly. However, the IRS has not provided a definitive list differentiating dealer vs. investor. Based upon various court decisions, relevant factors include:
- Source & amount of income
- Value, volume, & frequency of tax payer real estate transactions
- Length of property ownership
- Whether a business office & brokers were used to sell the property
Whether you’re an investor or a dealer, a Delap tax advisor can help you implement the tax planning strategies that will best accomplish your business objectives, on taxes and otherwise. Just don’t wait until you’re selling property to consult with a CPA, by then it might be too late.