Are You A Dealer?
November 17th, 2009
Are You A Dealer?
One of the most popular ways that both beginning and experienced real estate investors choose to generate cash flow for their real estate investing is through a quick sale or flip of a property. These transactions often generate the income that an investors lives off of while building a portfolio of holding properties to generate future wealth. The Internal Revenue Service may determine that you are a real estate dealer if you buy and flip properties based upon what they determine your intent was when you purchased the property. The factors used by the Internal Revenue Service to determine dealer status are as follows:
Number Substance and Continuity of Sales the more sales are made over a period a time the more likely a sales intent exists.
Extent and Nature of Efforts to Sell Property the more constant and intense the sales and marketing effort the more likely sales intent exists.
Taxpayer Purpose for Acquiring Holding and Selling Property expressed intent via written and oral communication.
Ordinary Business of the Taxpayer Taxpayers whose primary business is real estate such as a broker or developer have a tougher burden of proof.
Use of a Business Office for Sales gives appearance of an business and not an investment.
The largest concern that a real estate investor who does a lot of flips has is that the laws related to dealer status are vague and the determination of intent is subjective with no clear cut criteria. This is a heavily litigated area of tax law and court opinions are often inconsistent and vary from judge to judge.
How does dealer status hurt the real estate investor?
If the Internal Revenue Service determines that you are a real estate dealer you can lose the following taxsaving benefits:
Depreciation rental properties held by a real estate dealer are not allowed a deduction for depreciation.
Rental Income rental income from properties held can be determined to be ordinary income subject to self employment tax.
Installment Sales dealers who sell property using the installment method may be forced to report the whole gain in the year of sale instead of deferring gain until actual dollars are received.
Tax Free Exchanges dealers are not allowed to do Section 1031 exchanges with properties sold.
Tax Planning Considerations
There are several tax planning considerations and strategies that one can use to manage the implications of the dealer status. They are as follows:
Use of Multiple Entities for the Different Types of Real Estate Investing A good strategy is to use a separate business entity usually a C or S Corporation to flip properties and other business entity usually an LLC or group of LLCs to hold rental properties. Another entity could be set up to deal with properties sold on the installment method.
Use of the Cash Basis of Accounting Using the cash basis of accounting for the dealer entity helps offset the profits because deductions can be taken for all expenses paid prior to year end and lower both the income and selfemployment tax that will be due on the taxable income.
Use of Lease/Option Instead of Installment Sale The loss of the installment sale deferral can be eliminated by using a lease/option instead. The primary issue here is when did the sale occur or constructive ownership. The lease/option agreements must be prepared properly to ensure that the lease/option will not be determined to be a constructive sale. Consult a real estate attorney to ensure that the agreements you are using conform to the proper standards to avoid this issue.
About the writer: Ted Lanzaro CPA The Millionaire Tax Advisor owns and operates Lanzaro CPA LLC a tax strategy accounting and business advisory firm with offices in Shelton CT. The firm concentrates on providing advisory services education and products design to promote business development tax savings and wealth creation. He can be reached by phone at 2039245760 or via email at Tedlanzarocpa.com. You can subscribe to The Millionaire Tax Advisor Newsletter at www.millionairetaxadvisor.com. You can also get a copy of Teds special report 10 Proven Totally Legal and Effective Tax Strategies That Will Put Thousands In Your Pocket Every Year at his website www.lanzarocpa.com.
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