Real estate investors and property dealers may seem like the same thing. But how does the IRS classify someone who makes a profit turning real estate properties? Generally, a dealer purchases property with the intent of reselling it. An investor, on the other hand, purchases property because of its appreciation, rental income, or both. It is important to make sure you classify your properties correctly to avoid huge tax issues.
Can’t I have Both Dealer and Investor Properties?
You can have both types of property. However, it is extremely important that you distinguish each type of property in bookkeeping and records. Make sure to distinguish which are dealer properties and which ones are investment properties.
What Makes You a Real Estate Investor
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A real estate investor’s primary intent is not to purchase property in order to sell it. Instead, the investor’s goal when acquiring property is to either have it appreciate in value or to use it for rental income. Investor properties do not change hands often and they are not sold often. When a property is purchased for the sole purpose of producing rental income, it’s considered an investment. The IRS and the courts consider you are holding property as an investor if you acquire the property by either:
- an inheritance
- dissolution of a trust
- foreclosure from a mortgage
Investors typically hold on to the property longer than a dealer does. One way to know you are an investor rather than a dealer is by how long you hold on to properties. The longer you hold them, the more likely it’s an investment property. Investors do not buy a property, remodel it then resell it. They may do some remodeling to increase the value of the property, or to make it more marketable when it comes to renting. They do not remodel just to be able to sell the property again as a course of business.
What Makes You a Property Dealer
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A property dealer buys and sells numerous properties over a year. There isn’t a magic number of transactions that are needed to classify you as a dealer. There have been court rulings that deemed a single acquisition a dealer status. For example, if the property has already been “sold” to a third party before it has been acquired, it can be given dealer status. This is because it was purchased with the intent of reselling.
In another case, the Goldberg case, the courts deemed the selling of 90 houses as an investment. Why? Because the homes were built for the purpose of renting during World War II. After the war, they were sold. But the intent of obtaining the original property was to create rentals. Once the need for the rental homes had ended, they were then sold. The courts deemed them as investment properties, based on why they were obtained.
What difference does it make?
Being classified as a dealer or investor can change how your taxes are figured at the end of the year. Your tax preparer will need to know your classification to be able to figure your taxes accurately. This can help you avoid penalties. Here are a few of the benefits and advantages of each classification.
Advantages and Disadvantages for Dealers
- Profits for dealers are subject to taxes for ordinary income rates and self-employment rates.
- Dealers cannot depreciate property intended for sale.
- A dealer doesn’t have access to the tax-favored installment method of reporting property dispositions.
- They also cannot use the Section 1031 tax-deferred exchange on properties.
- Dealers can, however, can deduct expenses, commissions, advertising fees, legal fees, and real estate selling expenses on their taxes.
- Losses for dealers are not subject to the $3000 capital loss cap that applies to investment properties.
Tax Breaks Investors May Benefit From
- Investors have the benefit of being taxed at a capital gain rate of 20% or less.
- They are not subject to self-employment taxes.
- Investors get tax breaks. For example, if you make a $90,000 profit on a sale, as an investor your taxes may be $18,000 or less. If you are a dealer, you may pay as much as $46,000 in taxes.
- An investor can depreciate property.
- They may defer taxes.
