There are 3 categories the IRS uses to describe real estate investors that can dramatically change the taxpayer’s tax liability, namely:
1. Real Estate Dealer Status – 2. Real Estate Developer Status – 3. Real Estate Professional Status. Do you know which one are you?
- Real Estate Dealer Status: is defined as someone who is involved in real estate as a “trade or business” This designation is given on a property basis. That means it is possible for the taxpayer to be treated for tax purposes as a dealer on one property and an investor on another. This is determined on the taxpayer’s intent towards the property. For example, if the taxpayer buys property for a quick sale or “flip” they are considered a dealer with respect to that property. This is mostly common for investors who rehab properties and purchase foreclosures for quick sale (this is commonly known as fix-n-flip). If the taxpayer is treated as a dealer, the real estate income from that property is considered self-employment income and subject to self-employment tax on the net income derived from that particular property. Another disadvantage of dealer status is gains are treated as ordinary for income tax purposes. The IRS uses a specific criteria to determine real estate dealer status, and the most important criteria is the frequency of sales and the purpose for acquiring the property. Therefore, the IRS is looking for properties that are primarily held for sale. There are ways to avoid self-employment tax through tax planning.
- Real Estate Developer Status: this status is also determined on a per property basis. Developers are real estate investors who are in the business of producing inventory and are subject to Uniform Capitalization Rules. This means the taxpayer cannot deduct depreciation and other expenses that are general and administrative and all carrying costs. Taxpayers have a difficulty understanding why they cannot deduct the money they spent on costs in the year they spent the money. Detailed bookkeeping of other costs will ensure that non-capitalizable expenses are deducted in the year they are incurred.
- Real Estate Professional Status: In order to claim this status, you must meet a two-pronged test:
- You must spend more than 50% of the personal services performed in all trades or businesses during the tax year on real estate. Specifically, this time must be spent in real property trades or businesses in which the taxpayer materially participates.
- The taxpayer must have spent more than 750 hours of services during the tax year in real property trades or businesses in which they materially participated.
The reasons for the above is because rental activities are generally considered to be passive activities unless you meet the above rules and still satisfy the material participation test by meeting the 500 hours per year on that activity in order to be considered non-passive.
The advantages of investing in real estate is the ability to offset noncash expenses such as depreciation and amortization against income.
Know your real estate status, it may make a difference in the tax you pay or save.