People who buy and sell (or “flip”) real properties often call themselves real estate “investors,” but this may not be a correct classification in the eyes of the IRS. In the business of real estate, the IRS uses a specific set of criteria to determine whether these taxpayers are operating as “dealers” or “investors.” Should you be classified as a real estate dealer, you are deemed to be in an active trade or business. We will discuss why this is an important distinction.
Determining dealer status is often difficult. If you buy and sell properties on a daily basis, then the IRS may take the position that this is your principal business activity. Similarly, a CPA who charges clients a fee for his or her services actively participates in the business of accounting. If this CPA were to carry out a real estate deal or two on occasion, then he could more easily be considered an investor because the activity is not necessarily part of his primary trade.
This distinction is significant because dealers are subject to employment taxes at the rate of 15.3% of business profits (assuming a sole proprietorship). This tax rate would be consistent with any normal business owner. Additionally, dealers are unable to utilize the installment method for sales of real estate. In other words, if dealers dispose of a property and take payments over an extended period, they are unable to defer profits into the future and must instead pay tax on the sale immediately.
How are real estate flips taxed?
While it is undoubtedly a subjective issue, the IRS examines the “intent” of the taxpayer, often using the following criteria:
1. Purpose for which the original acquisition was made
Did the purchaser intend to hold the property and gain a financial return? Is buying and selling part of his or her everyday business? These questions of intent are essential to determining one’s status as a dealer or investor. A buyer should know what he wants to do with each property at the time of purchase so that he can establish his intent for each acquisition.
2. Duration of ownership and the purpose for which it was sold
Another important criterion for classification is the amount of time the buyer held the property before selling. Investors will often maintain ownership of the property for more considerable periods of time, as opposed to flipping or making some improvements and selling soon after. However, time is a subjective matter, and there is no set duration for labeling the property one way or the other. The IRS will again examine the intent of the property owner at the time of sale of the property.
3. Frequency and continuity of sales
Put simply, the more properties you buy and sell throughout a calendar year, the more likely you are to be classified as a dealer over an investor. This general rule, like every other detail under scrutiny by the IRS in these real estate situations, is not fixed for every person or property. There is no set number of property sales to determine one’s status as either a dealer or investor.
4. The extent to which improvements (if any) were made to the property
Properties that are bought, fixed up, and sold will typically earn “dealer” status. However, this is not always true, and there may be more ambiguous situations such as smaller improvements or fixing a property over time that will require the examination of other criteria to solidify your classification by the IRS.
5. Control and effort expended by the taxpayer in the sales process
In many cases, spending less effort and having less control over the sales process implies an “investor” situation. The amount of energy you put into a business activity is often directly related to how much time you spend with it, and we know that time is one of the essential factors in determining the status of your real estate business.
6. Use of real estate brokers and extent of advertising initiatives
There is some overlap between Criteria 5 and 6 in that the use of real estate brokers and advertising may limit or expand the involvement of the property owner. Extensive marketing implies greater sales efforts, especially when compared to more passive marketing approaches. Contrarily, the use of real estate brokers would lessen the need for efforts to be made by the property holder. As mentioned previously, the IRS tends to uphold dealer classification for taxpayers who expend more effort in the sales process.
7. Ordinary business and experience of the taxpayer
As discussed earlier, your status as either a dealer or investor is partially dependent upon how the property relates to your principal business activity. If your primary business focus is the buying and selling of real estate, you are more likely to be seen as a dealer by the IRS. A CPA or other business professional who occasionally purchases or sells properties may be more likely categorized as an investor.
8. Income from the sale compared to other sources of income and employment
This detail directly relates to the previous point, as your income is often a reflection of your business activity. Your employment (or lack thereof) and corresponding income are a few of the many factors examined by the IRS in determining dealer/investor classification. Your status may be tipped more toward the “dealer” end of the spectrum if your income is derived primarily from selling properties.
9. Nature of the taxpayer’s other real estate holdings
While the IRS determines your position as a dealer or investor per property, the nature of your other property holdings may have some influence. For example, in the case of a real estate professional who fails to establish his or her intent at the time of purchase or sale of a property and owns several other long-term investment properties, the IRS could safely assume the property in question was purchased for similar use.
10. Reluctance or desire to dispose of the property
This criterion overlaps with many of those above, as it relates to the amount of time the owner held the property and his or her intentions regarding the sale of it. For instance, if you are more reluctant to dispose of the property, it might seem likely to the IRS that you are holding it for investment purposes.
The most crucial issues described in the above criteria appear to be the taxpayer’s volume, frequency, and consistency of real estate sales. Said differently, if you have a history of selling a lot of properties and do not have other business activities, then this may weigh in favor of classification as a dealer.
However, “dealer” and “investor” labels are determined on a per-property basis. So, while the IRS might consider you a dealer concerning a particular property or set of properties, it may not label you this way for all of your properties.
It may be advantageous to have some flips grouped in one taxable entity (for example an LLC possibly taxed as an S Corp) and have “buy and holds” in a separate entity. Accordingly, having a formal structure in place may allow the IRS to look favorably at the taxpayer’s investment intent. Be sure to employ a CPA who is well-versed in real estate matters and can determine the optimal business structure for your unique situation as a real estate professional.