For real estate investors it has become critically important to differentiate between being an “investor” and a “dealer”, especially after the Clinton Tax Act. A commercial real estate developer who buys large tracts of land, subdivides them and sells individual lots would be considered a dealer in most cases.
If you are marked as a real estate dealer for tax purposes, you will be taxed (up to 39.6%) on the full gain on a piece of property up front when the property is sold. You also lose the tax advantages of the installment sale when you sell real estate.
As an investor, you could be taxed as little as 28% under the capital gain tax laws for the same transaction. Until recently the tax difference between being a dealer (31%) and an investor (28%) was minimal. The Clinton Tax Act changed all of that by increasing the possible spread to 11.6%.
An 11.6% additional tax on a $250,000 real estate transaction equates to $29,000 of extra tax on the same transaction, all because you’re considered a dealer. For the average real estate investor, the dilemma is how to avoid being marked as a real estate dealer by the IRS.
Real estate investors do (and should do) everything possible to avoid being tagged with dealer status. There are many schools of thought on what warrants a dealer in the eyes of the IRS and what type of deals triggers the IRS to call you a dealer. Unfortunately, there is no singe answer to the question of how to avoid dealer status.
If you routinely develop, subdivide, market and sell large tracks of land, you will likely be tagged as a dealer. The real debate lies with real estate investors who routinely flip houses. How many deals per year are too many to be considered an investor by the IRS?
If you’re flipping (buying and selling in 12 months or less) 1 to 5 houses per year you probably have little to worry about if you keep a low profile. Especially if you keep a few houses here and there as rentals so you can show rental income on your tax returns.
Once your real estate investing business progresses to the point where you’re flipping 20+ houses per year you’re in danger of being tagged with dealer status. It’s a good idea to keep a few properties every year as rentals or lease/options to show passive real estate income on your taxes. If the IRS sees huge capital gains from multiple deals with no passive rental income you will raise your visibility and increase the danger of acquiring dealer status.
If you have one business that flips a large quantity of houses or develops tracts of land, you may want to shelter it in another entity from your passive investment business. Being tagged as a real estate dealer is never beneficial and you want to do whatever’s possible to maintain your real estate investor status.
Layne Parker has been investing in residential and commercial real estate since the age of 17. He now teaches others how to do the same. Click Here for a FREE CD and Special Report on how to start investing in real estate with no cash, credit or previous experience.
