Real Estate Owners Can Achieve More Favorable Tax Treatment when Answering the Question: Am I a Dealer or an Investor? by John G. Ebenger
Posted on June 26, 2014
It is a little-known fact that real estate developers can reap more favorable tax treatment of property sales depending on how they classify and distinguish these activities. Typically, developers/dealers treat profits and losses from the sale of real property as ordinary income. Depending on the taxpayer’s income and filing status, ordinary income may be taxed at the 39.6 percent rate (or higher, based on the loss of certain deductions and the new “Net Investment Income Tax” rules.) However, under certain circumstances, real estate owners may take advantage of the preferential 20 percent capital gains rates when they sell property they held for investment.
How do real estate owners, and possibly developers, make the distinction between property sales to qualify for favorable tax treatment? The answer can be found in the real estate owners’ and developers’ intents to acquire, hold and sell the property; their conduct; as well as the frequency and substantiality of their property sales. Specifically, property owners and developers must prove they are investors, rather than real estate dealers.
Dealer or Investor?
A real estate dealer is a person who purchases real estate and sells it to customers “in the ordinary course of his or her trade or business.” Because these sales occur as a part of a dealer’s “ordinary course of business,” the dealer records the sale as a gain or loss of ordinary income.
In contrast, a real estate investor purchases and holds property over time, typically more than one year, in order to realize appreciation in value. Because investment property is considered a capital asset, proceeds from the disposition of the property is subject to capital gains tax.
To determine whether property sales are conducted by dealers or investors, the courts consider the following questions of fact:
1. Was the taxpayer engaged in a trade or business? If so, what business?
2. Was the taxpayer holding the property primarily for sale in that business ?
3. Were the sales contemplated by the taxpayer “ordinary” in the normal course of that business?
When responses to these questions are affirmative, the courts categorize the developer as a dealer, for whom profits and losses from sales of the property are subject to ordinary income.
Despite this distinction between dealer and investor status, there are times what a real estate dealer may also act as an investor. Subsequently he or she may benefit from capital gains treatment on specific property sales, depending upon the relationship between the nature of a dealer’s business (i.e. a residential development or dealer in unimproved real property) and the nature of the specific property for sale (i.e. improved or unimproved, commercial or residential.) For example, when a residential developer sells unimproved real property to a commercial buyer, he or she may be eligible for capital gains treatment because the nature of the developer’s business (residential development) is unrelated to the nature of the property sold (commercial.) In these instances, it is important for developers to hold sale properties separate and apart from investment properties.
Property Held for Sale or Investment?
The conduct of the real estate developer and his or her efforts to sell a property play a significant role in determining his or her status as dealer or investor. Developers who seek capital gains treatment of property sales must rely on case law and the following eight factors that the tax courts have historically considered when deciding tax status:
• The nature and purpose of the developer’s acquisition of and duration of ownership in the property;
• The nature and extent of any improvements the developer made to the property;
• The nature and extent of the developer’s efforts to sell the property;
• The extent of the taxpayer’s efforts to develop, subdivide and advertise the property in order to solicit buyers and increase sales;
• The character and degree of supervision the developer exercised over any representatives selling the property;
• The use of a business office in the sale of the property;
• The number, extent, continuity and substantiality of the developer’s property sales; and
• The time and effort that the developer devoted to the sale
Not one of these factors is more important than the others. Rather, the courts look at a combination of developer’s actions and his or her intentions when determine his or her role in property sales and the resulting tax consequences. Because intents can change over time, developers must maintain detailed documentation proving when and why they deviated from their original objective to hold and sell the property and realize the resulting tax benefits.
The classification of a real estate developer’s status as a dealer or investment is not a black and white determination. Rather, developers must consider the various nuances to the tax laws and weigh the obvious and hidden risks and rewards of each designation before taking any actions.
The Real Estate Tax professionals with Berkowitz Pollack Brant have extensive experience helping domestic and international developers, property owners and construction firms to develop and implement advantageous tax, compliance and transaction strategies.
About the Author: John G. Ebenger, CPA, is a director in the Real Estate and Tax Services practice at Berkowitz Pollack Brant. For more information, call (561) 361-1010 or e-mail email@example.com.