IRS Factors on Dealer

What it Mean to be Classified as a Dealer

There is a difference between an investor and dealer in the U.S. However, investors who own multiple properties and operate in a business office engage in a lot of flipping and turnovers throughout the course of their business. Come tax season, these investors are likely to be designated as dealers.

What does a dealer status mean really mean? The difference is on the profits of the property turnovers and the appropriate taxes to be paid. Investors’ profits are taxed at the lower capital gains rate, provided however that the investor has owned the property for more than one year. The dealers’ profits, on the other hand, are taxed as ordinary income, and are much higher in tax rates.

Defining the IRS Code 1221

The IRS Code 1221 defines a capital asset as the property that is held by the taxpayer, regardless of its connection to his trade or business. But this does not include the property or properties held by the taxpayer primarily intended for sale to customers in the ordinary course of his business or trade. Typically, this means that real property held primarily to be sold are taxed as ordinary income with rates up to 39.6 percent of the total amount. Capital asset or investment properties on the other hand are taxed as capital gains at a maximum of 15 percent.

What Dealers do

Upon learning this IRS rule, property investors structure their real property sales to avoid paying higher real estate taxes and being called dealers. According to the IRS, a property investor basically trade for profit-motivated reasons such as long term appreciation, dividends and interest. The dealers on the other hand hold property primarily for sale and profit purposes, even on short periods.

In the world of real estate, dealer rules and mechanics can become a bit shadowy and murky. Their secrecy has become a severe problem that even a client or a potential buyer when asks for his/her opinion, if the sale will result in capital gain, the answer would be no one knows.

IRS key factors in determining the difference

The IRS uses the holding time of a property as the key factor to determine whether someone is a dealer or an investor considering the number of sales within a year. Only properties that are held for longer than one year are applied with the capital gains tax rate. The longer the property has been held, the better chances the property could qualify as a capital gains rated property. On the other hand, a large number of properties only held for short periods of time and sold to customers could earn the seller the dealer status.

In short, the holding time plus the number of sales determine a dealer from an investor. Moreover, there are also other elements that can influence one’s investor status. These elements include; the number and nature of improvement made on the property, the level of engagement with the sale, plus whether the seller maintains a business office.

Property investors hire a broker to handle their sales. Dealers on the other hand tend to have a higher level of personal engagement in their transaction process. They commonly handle directly their own property sales.

Property investors should avoid making excessive improvements to the property. Avoid developments in particular such as; grading, rezoning, subdividing, installing utilities and roads. In general, avoid improvements that would exceptionally increase the property’s value. Investor properties can only have improvements that are necessary for the property to be sold at market value. The presence of improvement and development activities plus the frequent sales are always treated as ordinary income rated properties.

The element for business offices and agreements centers on documenting the use of leading and fundamental words. It is recommended that investors pay a close attention to their word choices in documenting partnership agreements. Investors avoid the use of words like development but prefer investment instead.

Dealers can also own investment properties. In multiple properties, it is a fact that one or more of the investor’s properties can fall under dealer classification. However, it does not mean that all the properties will. I would not be difficult for the taxpayer to prove that the sale should be taxed as a capital gain, considering all the above factors. The investor will be called upon by IRS to prove that the investment property is separate from his dealer properties.

It is therefore recommended that if you own different lots, separate the ownership of these lots into several business entities but document the time spent on each property.

Advantages of dealers

When tax season comes, there are actually advantages for dealers. There are tax- deductible elements like losses on dealers’ properties which are treated as ordinary losses and interest expense on dealer-held property that can also be generally deducted from ordinary income. These are however subject to investment interest limitations.

While rules surrounding dealer and investor status are confusing, it is recommended to seek out a professional advice on how to take steps to achieve or avoid a certain status. A professional tax advisor is the best resource to analyze facts and help investors create a workable plan on the investor and dealer status.