We are frequently asked by clients whether their plans to buy and sell real estate will subject them to status as a “dealer” in real estate, and therefore subject their profits to ordinary income treatment and self-employment tax. In general, the sale of real estate held for investment or speculation will be treated as sale of a capital asset eligible for capital gains/loss treatment (i.e. “investor” status), unless the sale by the Taxpayer is deemed to be integral to a Taxpayer “in the business of real estate” (i.e. “dealer” status). Unfortunately, there is no single factor that guarantees that the Taxpayer’s activities will be for an “investment” purpose rather than a “sale,” but instead, the IRS and courts employ multiple factors to evaluate whether the facts and circumstances of each individual case indicates Taxpayer is an investor or a dealer. Different courts may use different factors, but in general, these factors include:
- The frequency and continuity of sales activity. Many courts have determined that, although no one factor is determinative, the frequency and continuity of sales is perhaps the most important factor. Usually a single sale will not result in dealer status if the Taxpayer does not intend to continue in the endeavor. However, in one case (Boyer), a taxpayer was deemed to be a dealer on his first transaction due to the extensive development activity which included having land rezoned, surveyed, platted, and installing sewers and streets. The more frequent and continuing the sales, the more likely the activities will be deemed to be in the business of real estate.
- Duration of Ownership. Holding the property for longer periods suggests intent to hold the asset as an investment rather than for sale. In one case, a Taxpayer sold 9 properties in the span of 3-4 years, but was not deemed to be a dealer because each of the properties that were sold were held for 4-6 years prior to the sale. Nevertheless, other courts have warned against placing too much emphasis on duration of ownership where other factors demonstrate an intent to hold the property for sale.
- Extent and nature of improvements & efforts to sell the property. The more time and effort spent to develop the property, subdivide, advertise, and market the property for sale suggests a dealer motive. In one case, a taxpayer (Byram) sold 22 parcels of real estate during a three year period for a net profit of $3.4 million. However, each of these sales were initiated by the purchaser (not Byram), Byram did not subdivide the land, advertise, nor did he spend much personal time or effort procuring these sales. As a result, the Court determined Byram was not in the business of selling real estate. On the other hand, if the Taxpayer has regular relationships with sales staff, brokers, or other affiliated professionals to assist in property sales, this suggests a business motive. Taxpayers who do not want to be characterized as a “dealer” should take appropriate steps to limit arguments that their activities constitute a business, for example, by ensuring their books and records show property held for an “investment” motive as opposed to “sale” or “development.”
- Use of a business office in the sale. Maintaining a business office for real estate suggests a business motive. In the above example, Byram did not maintain a separate office for the sale of real estate which contributed to the Court’s determination that he was not a dealer. However, in another case (Winthrop), the taxpayer was deemed to be a dealer even though they did not maintain a sales office or marketing plan because they sold more than 450 lots over an 18 year period.
- Time devoted to the sales and income derived from those sales compared to other income producing activities. This factor is important for those with day jobs or other income producing activities. The more time spent and income generated from real estate activities, the more likely you will be considered a dealer. For example, a physician who derived 88% of his income from a medical practice, with the remainder from real estate investments was not considered a dealer in real estate, but another doctor who sold 88 pieces of real estate over 9 years was deemed to be a dealer because his real estate income far exceeded his income as a physician. Investors who have multiple income producing activities such as professionals should maintain a log of time spent on real estate activities compared to time spent on other income generating sources to show that time devoted to real estate is insubstantial compared to other income producing activities.
- Intent of the Taxpayer. Courts generally place more emphasis on the Taxpayer’s intent at the time of sale. However, courts have recognized that a taxpayer’s motive can change over time. For example, if the Taxpayer originally purchase raw land as an investment, but later decides to subdivide and develop the land into tract homes, this would suggest a business motive even though the original intent may have been for investment. Keeping written documentation of an investment motive (e.g. in minutes or other correspondence) may be helpful in the event the IRS raises a challenge.
Due to the varying factors considered by the IRS and courts, it is often difficult in many cases to make a definitive determination whether your activities will result in “dealer” status. Nevertheless, whether your real estate income will be subject to a 15-20% capital gains tax rate as opposed to ordinary income (up to 39%) plus self-employment tax (15.3%) can be a significant difference, and therefore, planning your real estate activities in recognition of the above factors can have a significant impact on your tax liability.