What Is a Real Estate Dealer?
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What's the Difference Between a Real Estate Dealer and a Real Estate Investor?
The distinction between a real estate dealer and a real estate investor is important to the Internal Revenue Service. For example, a real estate investor enjoys a more favorable tax position by avoiding the self-employment tax applied to a real estate dealer’s profits.
It does not mean the tax situation is all bad for real estate dealers. Some tax benefits apply to those who deal in real estate as opposed to investing in it.
It’s important to note that someone can be both an investor and a dealer at the same time. Under the Internal Revenue Code, each property is looked at on a standalone basis. In other words, a real estate investor can have a portfolio of rental properties and still be considered a dealer with regard to a property they bought and subsequently flipped.
Tax Implications for a Real Estate Dealer
A real estate dealer pays regular income tax—up to 37%—on profits generated from the sale of a property. In addition, dealers pay a self-employment tax of 15.3% (the Schedule SE adjustment, however, puts it at an effective rate of 14.13%). By contrast, real estate investor profits are taxed as capital gains, and they are not subject to the self-employment tax.
Real estate dealers also lose the ability to depreciate property held for future sale and to defer taxes using a 1031 exchange.
Finally, a real estate dealer’s status affects the ability to offer installment sales. If a real estate dealer finances the sale of a property, taxes are due on the entire gain in the year when the sale occurred even if the dealer receives the income in the future (see IRS Publication 537). On the other hand, if a real estate investor offers to finance the sale of a property, the income from the sale is reported in the year it is received.
On the other side of the ledger, the IRS treats expenses such as commissions, legal and accounting fees, and marketing and advertising as regular business deductions for real estate dealers. They can also deduct any loss as normal business loss, and the amount is not capped at $3,000 as it is for investment properties. Real estate dealers can deduct the entire loss in the year it occurs or they can deduct it over time as a net operating loss.
Tax Comparison on $100,000 Gain From Sale of Property
|Real Estate Dealer||Real Estate Investor|
|Income tax (top rate 37%) = $37,000||Long-term capital gains tax (top rate 20%) = $20,000|
|Self-employment tax (14.13%) = $14,130||No self-employment tax|
|Total taxes due = $51,130||Total taxes due = $20,000|
In the example above, if the IRS classifies the investor as a dealer concerning the property, the tax burden is $31,130 higher than if they were classified as an investor. In addition, the investor has the option of using a 1031 exchange to defer taxes on the sale.
How to Qualify as a Real Estate Dealer for Tax Purposes
The IRS rules for real estate dealer status are broad; they focus on intent and point-of-sale attributes. In other words, if an investor buys a property with the intent of selling it, they will be a real estate dealer for that property.
Some tax professionals suggest that the number of properties a person buys and sells in a year determines their real estate dealer status. This idea is not entirely accurate because the IRS looks specifically at intent, as the Goldberg case proves.
Nathan Goldberg was involved in a business that built rental homes during World War II. For three years, Goldberg held the homes as investment properties, but when the war ended, so did the need for small rental units. The following year, Goldberg sold 90 homes.
The Fifth Circuit tax court ultimately decided that, despite the large number of property sales, Goldberg was not a real estate dealer. He was a real estate investor due to his intent—to build and hold the property as an investment.
So while the IRS will consider the overall number of properties bought and sold in a given year to determine dealer status, it will always look to establish the owner’s intent for the property.
Other Factors That Determine Real Estate Dealer Status
Beyond intent, other factors can contribute to real estate dealer status:
- The manner of acquisition. Property acquired as a result of inheritance or foreclosure of a mortgage is usually treated as an investment.
- How long the property was held. A real estate dealer will typically hold a property for a short period.
- The extent of improvements. A real estate investor can make repairs and improvements to increase rents, but extensive improvements—as in a fix-and-flip—indicate real estate dealer status.
- Marketing and sales activity. The IRS looks at the amount of effort involved in marketing a property for sale compared to the marketing activity of a passive real estate investor.
- Sales income as a percentage of total income. If the income generated from selling property makes up a significant share of the total, the IRS will typically consider the taxpayer a real estate dealer. This is also tied to time spent on buying and selling property. A taxpayer who spends most of the time engaged in buying and selling real estate for personal benefit is most likely a dealer, not an investor.
As a general rule, a taxpayer who buys real estate for appreciation and/or rental income is an investor. A taxpayer who buys real estate with the intent of selling it at a profit is a real estate dealer.
Examples of Real Estate Dealer vs. Real Estate Investor
The following scenarios illustrate the distinction between real estate dealers and investors in action.
Dave Developer is in the business of residential subdivisions. He owns several parcels of undeveloped land, one of which he sells to a commercial developer. Regarding this particular property, Dave could be considered an investor, and his profit from the sale could be treated as capital gains for tax purposes because the sale is outside the scope of his normal business activities as a real estate developer/dealer.
Peggy Podiatrist buys an office building with the intent of operating her medical practice in one suite and renting out the rest of the office space. After a few months, she decides to sell the building and rent space in a medical complex in a more desirable location. As for the sale, Peggy would be considered an investor, not a real estate dealer. Even though she held the property for a short time and aggressively marketed it for sale, her primary income comes from her medical practice; she intended to use the property as an investment when she bought it.
Leonard Landlord has a portfolio of rental properties. He then signs a purchase agreement to buy a fourplex. Before the sale closed, he decided the building did not fit his investment goals, so he lined up a buyer for the fourplex and promptly sold it to a third party. Even though Leonard derives his income from real estate investments, with regard to this particular property, Leonard could be considered a dealer since his intent at the time of closing was to sell it.
Brenda Beachcomber buys three adjacent beachfront lots and plans to build short-term vacation rentals. However, before construction begins, a change in local zoning laws prohibits the type of structures she had planned to build, so she sells them after holding them for just three months. On the surface, Brenda looks like a real estate dealer, but in this case, Brenda could still be considered an investor since her intent was to build rental units. Circumstances beyond her control forced the change in plans and the ultimate sale of the property.
Because each property stands alone and a taxpayer can be both a real estate dealer and investor at the same time, real estate investors need to maintain detailed records that document whether a property is an investment property or a dealer property. The tax consequences for mischaracterizing a sale can be enormous.
A real estate dealer devotes most of their time to (and income from) buying and selling real estate. The activities of real estate investors and dealers often overlap, but individuals must understand whether they are acting as a dealer or investor in each real estate transaction they complete. The IRS taxes these activities differently, so detailed records are essential.
- Fletcher Tilton. (n.d.) Real Estate Investor or Dealer? Converting Ordinary Income into Capital Gain. Retrieved from https://www.fletchertilton.com/1C2194/assets/files/News/Real%20Estate%20Investor%20or%20Dealer.pdf
- Internal Revenue Service. (2020.) About Schedule SE (Form 1040 or 1040-SR), Self-Employment Tax. Retrieved from https://www.irs.gov/forms-pubs/about-schedule-se-form-1040
- Internal Revenue Service. (n.d.) Publication 537 (2019), Installment Sales. Retrieved from https://www.irs.gov/publications/p537
- Goldberg v. Comm’r of Internal Revenue, 22 TC 533 (USTC 1954). Retrieved from https://casetext.com/case/goldberg-v-commr-of-internal-revenue-2