‘Investors’ In Real Estate Receive Better Tax Treatment Than ‘Dealers’ by Steve Messing, CPA (updated)
Posted on March 29, 2017
The phrase “long-term investor” as defined by taxpayers is not in sync with the Internal Revenue Service’s definition. The consequences of this disconnect can be quite costly. Profits from real estate sales can expose taxpayers to unexpectedly large tax liability if they behave more like a property “dealer” than an “investor,” at least in the eyes of the IRS.
If the IRS determines that a taxpayer is a “dealer” in real estate, he or she would be liable for ordinary-income tax on profits from property sales up to a maximum rate of almost 40 percent. On the other hand, an “investor” who profits from the sale of real estate held more than one year would pay the capital gains tax, which has a maximum rate of 20 percent plus the 3.8% net investment income tax.
The IRS often goes to court to dispute taxpayer claims that they should pay the capital gains tax instead of the ordinary income tax on profits from real estate sales. Learning how the IRS distinguishes a dealer from an investor is one way to minimize tax liabilities and legal expenses alike. But in a legal context, this distinction can be difficult to discern. The United States Tax Court has observed what it called an “indistinct line of demarcation between investment and dealership.”
There are some simple ways to fortify an individual’s tax status as a real estate investor. Taxpayers who are part of a real estate partnership or LLC, for example, should have anoperating partnership agreement stating that its purpose is holding investments that will appreciate. Include the word “investment” or “investors” in the name of the partnership and avoid using the word “development” or “developers.”
The partnership’s tax return should list its business activity as investment, not sales, and its balance sheet should label real estate holdings as investment assets, not inventory.
Some taxpayers have both investments and developments in their real estate portfolios, so segregating them under the ownership of different entities is another way to avoid over-taxation. It’s a good idea to put a development business in a corporation and an investment business in a partnership.
Property transfers from partnerships to corporations with common ownership are more likely to qualify for capital gains tax treatment than transfers between, say, two commonly owned partnerships. Section 1239 of the federal tax code prevents capital gain treatment of sales between related parties unless the transfer involves such non-depreciable property as land.
The United States Tax Court has various tests to determine how to treat proceeds from sales of real estate. Capital gains treatment applies if the real estate sales failed to form the basis of a trade or business. Capital gains treatment also applies if the taxpayer bought real estate with the intention of holding it for appreciation and then sold it due to such events as unfavorable zoning, public condemnation of the property, or a natural disaster.
However, no rule governs the number of lots that an land owner can sell as investments without raising the selling activity to the level of a “dealer.” So multiple sales of parcels alone may be insufficient evidence of dealership activity. In a court fight known as the Byram case, the Fifth Circuit Court of Appeals ruled that a taxpayer acted as an investor in selling 22 parcels of land over a three-year period, noting that the sales were too infrequent to suggest anything but an investment purpose and that the seller spent relatively little time finding buyers.
Indirect ownership of real estate might qualify investors for capital gains treatment, even if the property holding period is less than a year. Imagine a group of investors who form a limited liability company, or LLC, in January 2012. The LLC buys a piece of land in April 2012. Then the owners sell all of their LLC shares to a development company in February 2013. The sellers may qualify for capital gains treatment of any profit from their 13-month investment in the LLC shares, even though the LLC had owned the land for only 10 months. But beware: The IRS could challenge the use of a partnership or corporation to extend an asset holding period if the obvious motivation was tax-related.
Convincing the IRS that a piece of real estate is a capital asset, not an inventory item, has a potential downside. If a taxpayer sells a real estate investment at a loss, his or her ability to deduct the loss for tax purposes is limited. Capital losses can offset capital gains only, not ordinary income, and the maximum deduction from capital losses is $3,000 a year. In some court cases, the IRS has contested assertions by taxpayers that they incurred ordinary losses on property held for sale, arguing instead that the taxpayers incurred capital losses because their properties were held for investment. Interest paid in connection with the purchase of real estate provides limited deductibility, too, because it offsets investment income only, such as interest or dividend payments, not ordinary income.
Our real estate tax services group is very experienced in providing advice to new and established property investors. We are here to help.
About the Author: Steve Messing CPA is a senior tax director in the Real Estate Tax Services practice of Berkowitz Pollack Brant, where he focuses on tax issues for real estate partnerships, developers and landholders. He can be reached in the Miami CPA office at (305) 379-7000 or e-mail email@example.com.