The real estate investor and dealer classifications determine how the income earned by an investor will be taxed. The real estate dealer classification is scrutinized by the IRS and the definition is subjective.
Real estate investors purchase real estate with the intention of holding their properties and gaining a financial return. Real estate dealers buy and sell real estate as part of their everyday business.
The IRS defines a real estate dealer as a company or individual engaged in the business of selling real estate to customers with the purpose of making a profit from those sales. There is no definitive test or specific guideline that offers a final perspectiveon a classification for a taxpayer.
The following factors are among the most commonly weighed by the IRS as noted in past court cases:
· Purpose of the acquisition
· Length of ownership
· Number of transactions by investor
· Proportion of income from real estate sales
· Frequency of sales
· Amount of gain realized
· Nature of advertising for the properties
If an investor is classified as a dealer, they would be liable for ordinary-income tax on profits from property sales up to a maximum rate of almost 40 percent. Dealers also cannot take advantage the tax benefits of 1031 exchanges.
On the other hand, an if they are classified as an investor they would pay the capital gains tax which has a maximum rate of 20 percent plus the 3.8% net investment income tax.
This is clearly a very large difference – tax planning regarding entity/portfolio structuring and investment strategies is crucial. There are preliminary measures that investors can take to safeguard their investments from the dealer classification.
For instance, generally your first step when creating your portfolio is forming a partnership or LLC; language in the operating agreement stating that the purpose is holding investments for appreciation is best practice.
Additionally, when filing the partnership’s tax return be sure to list the business activity as investments. The best practice for investors that invests in buy and holds, fix/flips and/or developments is to segregate their accounts into different entities to limit their liability of over taxation due to an incorrect classification.
All investors, agents and business owners should implement best practices regarding their portfolio structuring and tax planning. Camuso CPA PLLC offers a series of services to develop and tailor a first-rate advisory system for your real estate investment needs. Reach out to our team regarding any questions about portfolio planning or establishing a first-rate comprehensive tax strategy. We are the people to call for any CPA tax designation in Charlotte.