By Andrew Cohen, JD, LL.M, Friedman LLP
When it comes to purchasing and selling real property, taxpayers face the question: am I a real estate dealer or investor?
The distinction is important as it determines the tax treatment on any subsequent sale.
To help identify where you fit, we’ve outlined what you need to know about making the distinction.
To summarize, if the taxpayer is a dealer in real property, the gain recognized will be taxed as ordinary income; and if the taxpayer is an investor, the gain recognized will be a capital gain.
Although an individual real property broker or developer is most likely considered a dealer in real property, the Tax Court has held that this label may be avoided if certain actions are taken.
That being said, when there is a net loss for the year on total sales of real property, the taxpayer may want to be considered a dealer of real property rather than an investor.
To benefit from the reduced capital gain tax rates, a taxpayer must establish that the real property sold was a capital asset, which by definition includes real property not held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business.
The definition of the term “business” has been established in case law.
The Tax Court adopted the following definition of the term business: “implies that one is kept more or less busy, that the activity is an occupation.
It need not be one’s sole occupation, nor take all his/her time. It ordinarily is implied that one’s own attention and efforts are involved.”
Following the Robert L. Adams case, there were several factors that the Tax Court implemented to determine whether a taxpayer is a dealer or an investor in real property.
These factors include: 1) the purpose for which the property was acquired; 2) the purpose for which the property was held; 3) the improvements, if any, made to the property; 4) the extent and substantiality of the sales; 5) the nature and extent of the taxpayer’s business; 6) the extent of advertising and promotion of the sale of the property; and the listing of the property for sale directly or through a broker.
The properties were purchased by Mr. Adams, appreciated in value, and were then sold to realize the gain on appreciation, without any real effort on his part.
It can be inferred from this that if non-real estate professionals who frequently invest in real property can establish that they are passive investors in real property, they can establish that they are investors in real property, even if sales are relatively frequent.
Moreover, brokers and developers can segregate their investment and dealer properties into separate groups to avoid the dealer label. Developers can also segregate portions of land into separate, distinct groups.
Although each transaction is viewed on a case-by-case basis, segregation of investor and dealer property may be one way to reduce the dealer designation.
However, in a loss situation, a taxpayer might want to be considered a dealer in real property.
When selling real property for a loss, the taxpayer will incur an ordinary loss that can be utilized to offset ordinary income.
This will produce a greater tax benefit than if the property was held for investment, causing a capital loss to be incurred.
In many cases, it is in the taxpayer’s best interest to avoid being considered a dealer in real property, as this could subject the taxpayer to higher tax rates and limit the taxpayer’s ability to enter into a 1031 exchange.
Conversely, a taxpayer may want to be considered a dealer when there is a loss situation and more favorable tax benefits can be obtained.
Applying the rules as to whether a taxpayer is a real property dealer or investor is complex. That’s why it’s important to engage a tax professional with knowledge of the applicable rules and their impact.