Real Estate Investor vs. Dealer: Understanding the Tax Differences
Introduction
Real estate can be an excellent investment, but how the IRS views your actions will have an effect on your taxation. The question of whether you are a real estate investor or a real estate dealer will affect how you pay tax and benefit from tax incentives.
It is important to understand the distinction between the two before you purchase and sell real estate.
Who is a Real Estate Investor?
The real estate investor is someone who buys real estate to earn from it by way of appreciation, rentals, or any other means in the future. The investor usually holds onto his real estate as an investment and not as inventory for resale.
Some examples of real estate investors are:
- Acquiring rental property to earn from monthly rent.
- Purchasing land that is expected to appreciate.
- Holding onto commercial real estate as an investment.
Real Estate Dealer: Definition
A real estate dealer buys and sells real estate in order to conduct his or her trade or business. Generally, a dealer buys real estate with the purpose of making improvements and then sells it at a profit.
In other words, where a taxpayer buys a property, makes necessary improvements in it and sells it within a short span of time for a profit, he/she would be classified by the IRS as a real estate dealer.
How is Dealer Status Distinguished from Investor Status?
It is generally determined through the following criteria:
- Purpose of the purchase of the property.
- Activities performed during the ownership of the property.
- Circumstances of sale of the property.
- Frequency of transactions.
Since there is no one test for classification, all the facts and circumstances are considered by the IRS.
Taxes for Real Estate Dealers
If the taxpayer is defined as a dealer, real estate becomes inventory. The following tax effects arise in connection with such classification:
- No Depreciation Deduction
Inventory property cannot be depreciated.
- Ordinary Income
Any gain from sales of properties will be taxed as ordinary business income, which means that this kind of income will be taxed at higher rates compared to long-term capital gains.
- Not Eligible for Section 1031 Exchange
Real estate dealers are usually not entitled to utilize Section 1031 exchange to defer taxes.
- Cannot Utilize Installment Sale Method
It is forbidden for dealers to utilize the installment sale method in order to defer their taxable gains.
Benefits of Investing in Real Estate from a Tax Point of View
Real estate investing usually has the following tax benefits:
- Depreciation Deduction
Investors have an opportunity to depreciate the property in order to decrease their taxable income.
- Long-Term Capital Gains
Qualifying properties may be taxed as long-term capital gains, which are taxed at lower rates compared to ordinary business income.
- Section 1031 Exchange
An investor can defer capital gains through exchanges of investment properties.
- Installment Sale Method
Investors have the potential to defer the tax liability on any gains over a number of years via the use of installment sale method.
Which Status Is More Favourable?
There is no universal answer. It all depends on what the business objectives and the investment approach of an investor is.
In case an investor’s objective is to purchase, improve and then sell the property, being classified as a dealer may fit the investor’s activities.
In case an investor’s objective is to create wealth through appreciation and rent, being an investor may give more tax benefits.
It is important to know the tax implications before buying or selling a real estate asset.
Documentation Is Key
Since dealer/investor status is determined on the basis of facts and circumstances, it is important for the taxpayer to document:
- Reasons for the acquisition of the property.
- Purpose for which the property was held.
- Improvements to the property.
- Reasons for and the timing of selling the property.
Appropriate documentation is crucial to assist you when your actions come under scrutiny from the IRS.
Need Expert Advice?
Classification of yourself as either a real estate investor or dealer may affect your taxes. For any assistance that you need relating to purchasing, selling, and real estate tax planning, you can approach the experts at CCN Business Consulting.
CCN Business Consulting will be able to help you assess your situation and devise the best possible strategy for you.
