In a perfect world, taxpayers who own real estate would receive capital gains treatment when they sell the property at a gain and ordinary loss treatment when they incur a loss on the sale. In the real world, though, the tax treatment will turn on the determination of whether a taxpayer is a dealer or an investor. Here is what you need to know about the differences and how the determination is made.

The Different Tax Treatments

A real estate dealer generally is engaged in the business of selling real estate to customers with the purpose of making a profit from those sales. Real estate investors, on the other hand, hold property with the goal of enjoying long-term appreciation and perhaps rental income.

The question of whether a taxpayer is dealer or an investor arises from Section 1221 of the Internal Revenue Code. Under that provision, real estate held by a dealer for sale is not considered a capital asset. As a result, gains on sales made by a dealer are taxed at ordinary income tax rates (up to 37% under current tax law).

Property held by a real estate investor does qualify as a capital asset, though. Gains upon a sale are subject to a maximum of 25% to the extent there is depreciation recapture. Otherwise, the lower capital gains rate (15% or 20%), apply if the property was held for more than one year. For passive investors, the gains also may be subject to the 3.8% net investment income tax if the taxpayer’s modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly.

Those are not the only tax differences between dealers and investors. For example, dealers cannot benefit from tax-free Section 1031, or like-kind, exchanges. They generally also cannot defer taxes through installment sales or depreciate property held for sale. Also, dealers who receive rental income from real estate held for sale to customers are subject to the 15.3% self-employment tax on that income.

On the positive side, a dealer’s losses are deemed ordinary losses that can be applied to offset ordinary income without any limit. When an investor’s capital losses exceed capital gains, the excess can offset no more than $3,000 of ordinary income in a tax year (the balance is carried forward to future tax years). As such, dealer’s losses have the potential to offset more income.

Relevant Factors

The IRS has not published clear guidance for determining whether a taxpayer is a dealer or an investor. However, courts have stepped into the void, issuing numerous rulings that outline several non-exclusive factors that should be considered.

The courts have emphasized that no single factor is determinative. Not every factor will be relevant in every case, and factors may have varying significance depending on the particular facts and circumstances. Moreover, objective factors have more weight than a taxpayer’s subjective statements regarding their intent.

The most common factors cited by the courts include:

The purpose for which the property was acquired and held. Why did the taxpayer initially purchase the property? If the plan was to subdivide it and sell the parcels to customers, the taxpayer probably is a dealer. Conversely, if the taxpayer bought the property to hold onto for years, without any development plans, it likely is an investor. Notably, courts have recognized that intent can change — and that a taxpayer can have different intent for different parcels of property.

Any improvements, and their extent, the taxpayer made to the property. If the taxpayer engaged in development activities (for example, subdividing property, grading, or installing roads and utilities), courts lean toward dealer status. Bear in mind that development activities can convert property originally acquired for investment into property held for sale to customers. Development of one parcel, however, does not necessarily mean another parcel is not held as an investment. Investors could be developing property in order to add value and increase rent prices.

The frequency, number and continuity of sales. Courts typically view frequent and continuous sales of parcels of real estate as sales conducted by a dealer. Infrequent sales for substantial profits indicate real estate is held as an investment.

The extent and substantiality of the transaction in question. The focus here is on whether the taxpayer’s primary business involves developing and selling property. If not, the factor favors a finding of investor status. Courts consider factors such as:

• The number of past property sales by the taxpayer;
• Whether the taxpayer has a full-time job outside of the property; and
• Whether the taxpayer owns a construction, development, or broker business.

The extent of advertising. How was the property marketed? Extensive advertising for the sale of the property indicates dealer status. A lack of marketing efforts suggests investor status.

The listing of the property for sale directly or through a broker. Listing real estate for sale with a broker usually is a sign that a taxpayer is a dealer.

Note: The dealer/investor determination is made on a property-by-property basis. A taxpayer could be deemed a dealer for one parcel of property and an investor for another.

Proceed with Caution

Taxpayers should bear in mind that decisions made throughout their ownership of real estate can heavily influence their status as a dealer or investor — and ultimately the appropriate tax treatment upon sale. That includes how you classify real estate on financial statements and how you report your activities on your annual tax returns. We can help you take the right steps to achieve your tax objectives.

For more information, contact Tammy Partridge at [email protected] or 312.670.7444, or ask your ORBA advisor. Sign up here to receive our blogs, newsletters and Client Alerts.