Are You a Real Estate Dealer or Investor?
People engaged in frequent sales of real property need to determine whether they are real estate dealers or investors. The distinction is important because dealers and investors are treated very differently for tax purposes.
Tax Consequences of Dealer vs. Investor Status
Real estate dealers buy and sell properties as part of their regular business operations, with profits taxed as ordinary income and subject to self-employment tax.
Real estate investors purchase and hold properties primarily for long-term appreciation or rental income, typically enjoying favorable tax treatment such as capital gains rates and depreciation benefits.
Dealers and investors receive very different tax treatment, as shown in the following overview charts. Note that there are good and bad elements to each tax classification, but being classified as a dealer is usually not advantageous taxwise.
Real Estate Dealer Tax Treatment
Good:
- Dealers may fully deduct losses as ordinary losses, up to the annual limits on excess business losses—for 2024, $305,000 for singles and $610,000 for married taxpayers filing jointly.
- Dealers qualify for the 20 percent Section 199A qualified business income deduction.
- Since they are in business, dealers are not subject to the 3.8 percent net investment income tax (NIIT) on unearned income.
- Dealers deduct real estate selling expenses such as commissions, fees, and advertising as ordinary business deductions.
Bad:
- Dealers pay taxes at ordinary income tax rates up to 37 percent.
- Dealers get no depreciation deductions on their properties because the properties are business inventory.
- Dealers cannot use Section 1031 to defer taxes on inventory sales of property.
- Dealers cannot use the installment method to report their property sales.
- Dealers pay self-employment tax of up to 14.13 percent on their profits.
Real Estate Investor Tax Treatment
Good:
- Investors pay capital gains taxes on their profits and can qualify for the long-term capital gains rates of 0, 15, or 20 percent if they hold their property for more than one year.
- Investors can use the installment method to report their property sales.
- Investors can qualify for Section 1031 tax-deferred exchanges.
- Investors may depreciate their rental property and use Section 179 expensing on tax code–defined property such as kitchen appliances, carpets, and drapes and on qualified improvement property in commercial buildings.
- Investors can qualify for the Section 199A deduction.
Bad:
- Investors may deduct no more than $3,000 of their capital losses from ordinary income (after offsetting gains against losses).
- Investors can be subject to the 3.8 percent NIIT.
- Investors who invest in rental properties are automatically subject to the passive loss rules.
- Investors must treat selling expenses as reductions in sales proceeds; therefore, such expenses produce benefits at only capital gains rates.
- Investors suffer Section 1250 recapture on real property depreciation, which is subject to taxes of up to 25 percent, and Section 1245 recapture on personal property, which is subject to taxes at ordinary rates.
Since dealers pay tax on their profits at ordinary income rates (plus self-employment tax), while investors pay tax at capital gains rates, dealer status is particularly undesirable where real property is sold for a substantial gain.
Example: You earn a $100,000 profit from the sale of a property held for more than one year. If you are a dealer with income from other sources, your taxes could be as high as $51,130 (37 percent income tax + 14.13 percent self-employment tax). If you’re an investor, your taxes could be as high as $23,800 (20 percent capital gains tax + 3.8 percent NIIT). That’s a $27,330 difference ($51,130 – $23,800).
“Real Estate Dealer” Defined
A real estate dealer is someone who is in the business of owning property primarily for sale to customers. Real estate dealers resemble merchants or retailers of goods, except that their product is real estate. A real estate dealer’s holdings are inventory for sale to customers, the same as any merchant’s inventory.
Real estate dealers typically include (but are not limited to):
- Real estate flippers—people who buy homes, fix them up, and resell them quickly.
- Real estate speculators, who buy and sell many properties each year.
- Subdividers, who buy large tracts of vacant land, divide the tracts into smaller lots, and then resell the lots piecemeal.
- Real estate developers and home builders, who construct new houses and resell them soon after completion.
There is no definition of “real estate dealer” in the tax code. The IRS and courts look at the following eight factors. No single factor is determinative, but the first three are the most important:
- The number and frequency of sales.
The number and frequency of sales are the most important factors. Frequent and substantial sales are the hallmark of a real estate dealer. On the other hand, infrequent sales for significant profits indicate that an investor held the real property as an investment.- There is no set number of sales required to make a person a dealer. As the following chart shows, courts have been inconsistent in deciding how many sales are needed to be a dealer:
Dealer Sales Investor Sales 48 lots sold over 5 years 10 properties sold in 2 years 39 sales over 7 years 22 sales over 3 years 71 properties sold in 3 years 28 lots sold over 3 years 244 sales over 32 years 45 sales over 7 years
- There is no set number of sales required to make a person a dealer. As the following chart shows, courts have been inconsistent in deciding how many sales are needed to be a dealer:
- Intent in buying property.
A real estate dealer buys properties with the intent of making money from reselling them. A person who buys property to earn income and/or benefit from long-term appreciation is not a dealer. A dealer is in the business of buying and selling properties. - Extent of improvements.
Dealers often improve the property they own to increase its value for purposes of resale. For example, a person who frequently “flips” property would likely be a dealer. - Sales efforts.
Dealers make extensive efforts to resell their properties—for example, they hire real estate brokers, list their properties for sale, engage in advertising, and may have their own sales office and sales staff. A person who engages in extensive marketing efforts is more likely a dealer than one who takes a passive sales approach. - How the property is acquired.
Dealers go out and buy properties themselves. A person who acquires real property through an inheritance or gift is not likely to be viewed as a dealer. - Holding period.
Like any merchant, real estate dealers want to sell their inventory quickly. People who hold real property for a long time before selling it are much less likely to be considered dealers than those who hold their properties for a short time. - Income generated by sales.
A person is more likely to be viewed as a dealer if the income generated from selling real estate constitutes a substantial amount of the total income he or she earns. - Continuous effort.
Dealers work continuously throughout the year to sell their properties and spend substantial time at their business. A person whose sales transactions are only intermittent is not likely to be a dealer.
“Real Estate Investor” Defined
Real estate investors own property primarily to earn income from rents and/or long-term appreciation.
Unlike dealers, they sell their property infrequently, usually after a long holding period. But there is no prescribed minimum holding period to qualify for investor status.
Real estate held for a long time and appreciating in value with minimal improvements is likely to be deemed an investment. Investors can fix up their property, but they do so primarily to increase its rental value, not to earn more profits on a quick sale. You will generally be deemed an investor if you acquire property through inheritance or foreclosure of a mortgage.
You Can Be Both a Dealer and an Investor
Whether you are a dealer is determined on a property-by-property basis. You can own some property for sale as a dealer and other property as a long-term investment.
Example: Peter Miller, a real estate broker, purchased an apartment building and sold it two years later for a substantial profit. At the same time, he worked as a dealer in real estate: he was involved in several real estate sales businesses, including subdividing land for resale and home building. Nevertheless, the Tax Court found that the apartment building was not dealer property. Miller owned the apartment building primarily to earn rental income, not for resale purposes.
But if you are a real estate dealer, all the property you own can be subject to “dealer taint” and classified as dealer property.
Steps to Overcome Dealer Taint:
- Keep separate books, records, and bank accounts for your investment and dealer properties.
- If possible, establish a separate business entity, such as a single-member LLC, for your investment properties. Use a name like “investments” or “investors” instead of “development” or “developers.”
- Document your investment intent with resolutions, minutes, and similar paperwork.
- Never deduct your expenses for your investment property as business expenses; deduct them only as investment expenses.
- Use third-party brokers or agents when you sell your investment property, rather than selling it yourself.
Dealer Property Can Become Investment Property and Vice Versa
The classification of property can change over time:
- Dealer property can become investment property if your intent changes and is well-documented.
- Investment property can become dealer property if you decide to develop and sell it.
Example: An LLC purchased land with the intent to develop it but decided to hold it for investment during the subprime mortgage crisis. The Tax Court ruled the property was investment property at the time of sale.
Takeaways
- Real estate dealers are in the business of selling real property, while investors own property primarily for income and long-term appreciation.
- There is no definition of “real estate dealer” in the tax code; the IRS uses multiple factors to determine status.
- Dealers pay tax at ordinary income rates and are subject to self-employment tax, while investors benefit from capital gains rates and depreciation deductions.
- The same person can own both dealer and investment properties, classified on a property-by-property basis.
At Provident CPAs, we specialize in helping clients adapt to changing economic conditions. Whether you’re a business owner or an individual looking to optimize your tax strategy, our team is here to guide you through the complexities of today’s tax landscape. Contact us today to learn more about how we can help you achieve financial independence, even in the face of economic uncertainty.