Are you a distributor?
One of the most popular ways that beginning and seasoned real estate investors choose to generate cash flow for their real estate investments is through a quick sale or “flip” of a property. These transactions often generate the income that an investor lives on as they build a portfolio of “tenure properties” to generate future wealth. The Internal Revenue Service may determine that you are a real estate “dealer” if you buy and sell properties based on what they determined was your intention when you purchased the property. The factors the Internal Revenue Service uses to determine “distributor” status are as follows:
- Number, substance and continuity of sales: The more sales made during a given period, the more likely there is a sales “intent”.
- Scope and Nature of Efforts to Sell a Property – The more consistent and intense the sales and marketing effort, the more likely there is a sales “intent.”
- Purpose of the taxpayer to acquire, own and sell property: “intention” expressed through written and oral communication
- Ordinary Taxpayer Business – Taxpayers whose primary business is real estate, such as a broker or developer, have a heavier burden of proof.
- Use of a business office for sales: It gives the appearance of a business and not an investment.
The biggest concern a real estate investor who makes a lot of “turns” has is that the laws related to “merchant” status are vague and determination of intent is subjective without clear criteria. This is a highly litigated area of tax law and court opinions are often inconsistent and vary from judge to judge.
How does “merchant” status hurt the real estate investor?
If the Internal Revenue Service determines that you are a real estate “merchant,” you may lose the following tax savings benefits:
- Depreciation: Rental properties held by a real estate “dealer” are not allowed a deduction for depreciation.
- Rental Income: Rental income from maintained properties can be determined as ordinary income subject to self-employment tax.
- Installment Sales: “Dealers” who sell properties using the installment payment method may be required to report the entire profit in the year of sale rather than defer the profit until the actual dollars are received.
- Tax-Free Exchanges: “Dealers” cannot make Section 1031 exchanges with sold properties.
Tax planning considerations
There are several tax planning considerations and strategies that can be used to manage the implications of “dealer” status. They are as follows:
- Using Multiple Entities for Different Types of Real Estate Investing – A good strategy is to use a separate business entity (usually a C or S corporation) to “trade property” and another business entity (usually an LLC or group of LLCs) to hold rental properties. Another entity could be created to deal with the properties sold in installments.
- Use of the cash basis of accounting: The use of the cash basis of accounting for the “concessionaire” entity helps to offset the gains because deductions can be taken for all expenses paid before the end of the year and reduce both the income tax such as self-employment tax that will be owed on the tax base.
- Use of lease / option instead of installment sale: Loss of deferral of the installment sale can be eliminated by using a lease / option instead. The main problem here is “when did the sale” or “constructive ownership” occur. Lease / option agreements should be properly prepared to ensure that the lease / option is not 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 problem.