By Ted Lanzaro, CPA

Are You A Dealer? - 5 Factors The IRS Uses to Determine Dealer Status

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 investor 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 tax-saving 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 LLC’s) 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 self-employment 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.

    For more information about tax strategies for real estate investors, contact CPA Ted Lanzaro by clicking here.