Real estate investors get capital gains tax treatment when they sell. Dealers pay ordinary income rates. Whether the IRS considers you an investor or a dealer can be critically important.
There is no “yellow brick road” you can follow to safety if you want to be classified as an investor. Unlike 1031 exchanges, which have clear rules for tax-deferred sales, there are no rules or regulations for walking the line between “investor” and “dealer.”
If you are audited, the IRS will examine:
- Your business plan (a clearly written “investment plan”= more likely to be an investor, but magic words alone won’t save you)
- The frequency of your purchases and sales (more frequent=more likely to be a dealer)
- Holding period (longer holding period=more likely to be investor, but “one year and one day” does not make you safe)
- The existence of other sources of income for every day living expenses (no other support=more likely to be a dealer)
- Type of marketing (more marketing=more likely to be a dealer)
- How you present yourself (call yourself a flipper=the IRS will take your word for it. Flippers are dealers)
- The extent of repairs and improvements (extensive repairs and improvements=more likely to be a dealer)
Many experts recommend a balanced approach, with clearly “dealer” properties held in one entity, and hopefully “investor” properties held in a different entity. That makes it more plausible, if you are audited, that you are being truthful in your dealer vs. investor characterizations for your properties. They also recommend that properties acquired for future development by you (a dealer activity) be held in one entity as an investment until ready for development, and then transferred (with capital gains treatment) into another entity for the development phase. This is not a DIY activity–hire a good tax lawyer to set up your entities and paper the files adequately.
Finally, being a dealer is not all bad. Investors have to capitalize a lot of expenditures. Dealers can write them off on the current year’s taxes as a deduction. Plus, after considering the time value of money tied up in an investment, dealers with constant revenues, even after ordinary income taxes, might make more money than investors.