Real estate dealer vs. investor: knowing the difference could save you tax dollars
Aug 4, 2011
Because of tough economic conditions many taxpayers are selling real property to meet their cash needs. How the taxpayer reports the sale to the IRS dramatically impacts his or her tax liability.
In many cases, the property was purchased years ago with a low cost basis. It is beneficial to the taxpayer to report the sale of the property as a capital gain, which generates a tax at more favorable capital gain rates. The IRS, on the other hand, would prefer the sale be reported as a sale of property held for sale to customers and taxed at the higher ordinary income tax rates, and possibly subject to self-employment taxes.
A pro-taxpayer ruling by the Tax Court
In a recent Tax Court case (Mark S. Gardner, TC Memo 2011-137), the court ruled that a self-employed contractor who bought a parcel of land with the intent of building multi-family housing to generate rental income – but instead sold three subdivided lots due to financial pressures – was considered a real estate investor. As a result he was able to realize short-term capital gain on the lots’ sale.
This is a pro-taxpayer ruling that allowed the taxpayer to avoid self-employment taxes on the income generated by the sale. He instead received capital gain tax treatment -- in this case since short term, taxed at ordinary income tax rates.
What is real property?
Real property produces tax-favorable capital gain on its sale or exchange if it is a capital asset. A capital asset is broadly defined in IRS Code Section 1221(a) as “property held by the taxpayer” subject to a number of exceptions, including property held primarily for sale to customers in the ordinary course of trade or business.
Whether real property is held primarily for sale to customers in the ordinary course of the taxpayer’s business is a question determined by the circumstances of each case. In Gardner, the taxpayer purchased subdivided property (five lots), built a road to access the lots, built a house on one of the lots and conveyed it his brother, and then sold the other four lots in two separate transactions.
The IRS contended that the taxpayer was a real estate dealer, whose intent was to sell the subdivided lots to customers in the ordinary course of business, resulting in ordinary income subject to self-employment tax. The facts of the case supported the taxpayer’s claim that he was an investor and not a dealer, and the sale was not in ordinary course of his business.
Dealer vs. investor: what’s the difference?
If you are considering the sale of real property, it is important to understand the distinction between dealer and investor status. There are many different factors the courts use to determine whether one is a dealer or an investor, including:
- The nature and purpose of the property acquisition
- The length of time the property was held
- The nature and extent of any improvements
- Prior and current dealings in similar property
- The number, substantiality, extent, and continuity of the sales
The significant differences between ordinary (up to 35 percent and possibly self-employment taxes) and capital (15 percent or less) gain rates lead most taxpayers to seek capital gains treatment. Understanding the difference between real estate dealer status and investor status is essential to your ability to benefit from the lower tax.
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