Dealer vs Investor—The Looming Disaster
By Lee R. Phillips, JD
The Biden crew is planning big things for tax changes, but they haven’t done anything yet. Except – they have dumped a huge amount into the IRS. As I’ve mentioned before, the IRS has gone from a $12 billion budget to an $80 Billion 2022 budget. That’s an increase! The object is to hire more auditors and to increase the number of audits substantially. The IRS is now literally hiring anyone who can fill out an application.
Capital gains and 1031 exchanges are on the chopping block. If those two are changed, that will affect real estate investors. Taking away capital gains has been tried several times before, and it always fails because investment capital is the blood that flows through our economy. Capital gains tax treatment encourages long term investments, and without those investments, the economy cannot sustain itself. There is a thought that cutting capital gains will make the rich pay their fair share, but it is the middle-class investor that is really hurt by a bad change in the capital gains tax. I am not sure that capital gains will be done away with when the economy is as fragile as it is today.
Most of my students don’t use 1031 exchanges, so I don’t feel like the limitations proposed on 1031 will be as important to most of you as some proposed changes. The proposal is to limit 1031 exchanges to transactions under $500,000. Most of my students are playing with single family units that will fit in the under $500,000 category. While the capital gains and 1031 exchange changes may not be earth shaking and will require congressional approval, there is a looming disaster I can see coming.
I believe that there is a hidden threat to real estate investors that will likely be brought to the forefront as the number of audits are increased. The distinction between a real estate investor and a dealer may be brought front and center. Basically, a dealer is buying property for resale and an investor is buying property to hold for its rental value and appreciation. The distinction turns on the whims of the auditor. If there are a lot more auditors with the simple instruction of assess more taxes, real estate investors could easily be hit hard. The tool that may be used is the investor/dealer distinction because it doesn’t require any congressional action, and it is an extremely subjective call on the auditor’s part.
The auditor can simply say that your real estate sale was done as a dealer instead of an investor. The tax adjustment is big. Let’s say you make $90,000 on the sale of a piece of real estate. If you are an active real estate investor and doing a couple of deals a year, the auditor may well say you are a dealer instead of an investor.
With a dealer, that means all the income from your real estate deals is ordinary income. The $90,000 will be stacked on top of all your other income in the year you sell the property. You’ll pay ordinary income tax on the $90,000. Let’s say you make good money in your day job and the $90,000 is taxed in the highest tax bracket. That means you could pay around $50,000 in income taxes. That includes a 37% tax rate plus the self-employment taxes of 15.3%. Isn’t this fun?
If you are an investor and you get capital gains treatment (you held the property over a year), then you could pay as much as $18,000. That’s a lot different. All the auditor has to do in order to flip your tax bill from $18k to $50k is say your real estate deal went down as a dealer transaction instead of an investor transaction, which you claimed. As soon as the auditor changes your real estate status, the IRS gets an extra $30,000 out of you.
You can appeal the auditor’s decision, and if you make a really good case, you may win. However, as I have told you before, the IRS is into extortion. They did it to me on a perfectly clear deduction. My appeal came back as a totally unallowed deduction. I sued in tax court, and when the lawyer looked at it, he dismissed the case because there was no possible defense the IRS could argue. The average Joe couldn’t have taken the IRS to court, because the legal bill would have been more than the case was worth. The legal bill would have been over $10,000 and the case was only worth $5,000.
So, when the auditor tags you as a dealer, you are more or less stuck paying the lawyer $30,000+ or the IRS $30,000. When the auditor changes your tax status from investor to dealer, you’ll basically be SOL. (So Out of Luck – right?) With that small twist in your tax status, a huge bill can be assessed. It’s perfectly fair, because if you are rich enough to be investing in real estate, you certainly need to be paying your fair share.
With so much at stake, you need to start at the beginning of your real estate deal and make sure you have all the investor window dressing. It is to your advantage to be able to make a really good argument that you are an investor and not a dealer. If you have any chance of winning an audit appeal, it will come down to how you treated the deal.
The dealer/investor classification should be made by the IRS on a deal-by-deal basis. It applies to each specific property, not to you as an individual. You can have dealer properties and investor properties, so you had better know the difference and keep your books and records straight to distinguish between the two classifications.
It should be noted that as an investor you not only get capital gains treatment, but you also get to depreciate the property. You can also sell the property on a tax-favored installment method, and you can “sell” the property using a 1031 exchange to avoid taxes on the sale and then acquire another property without a tax.
The decision as to whether or not you are a dealer or an investor will hinge on a lot of little factors. There isn’t any set standard or way to distinguish between the two classifications. Every property has aspects of a deal property and aspects of an investor property. That’s why I think this is such an attractive audit target. The auditor can tag you as a dealer and his decision isn’t clearly right or wrong. Let’s beef up your chances of being determined an investor rather than a dealer.
Written Records
When you purchase a property, hold the property, and sell the property, your financial records and writings will directly or indirectly reflect what your intent is related to the property. You need to make sure that the records you have don’t shoot you in the head. In fact, you can “design” your written records to tip the scales in favor of investor status rather than dealer status.
If you don’t make the effort and pay attention all the time during your real estate transactions, you are leaving yourself to the mercy of the IRS auditor. Note that the word mercy doesn’t appear in the IRS handbook or the IRS tax code. If you are relying on the mercy of the IRS, you will be disappointed every time.
You need to clearly document your intent all the way along your real estate experience with each property – when you make the purchase, while you own the property, and when you sell the property. The sale seems to be the focus of the court cases. You can change your mind on your intent as you move through the ownership experience of a property. Just be honest in what your intents are. Of course, you are going to try and run everything through as an investment property rather than a dealer property.
Buying and flipping one house a year is different than doing it four times in a year. Actually, it really doesn’t matter how many you do, the question is did you intend to hold the property or sell it quickly after you purchased it. In theory every transaction stands on its own, but the pattern of your real estate dealings is obviously a factor in determining whether you are a dealer or investor.
Using LLCs taxed as partnerships will help because each deal will be in a separate entity. Yes, that violates my theory that you can’t have more than a couple of LLCs and manage them well. But an LLC taxed as a partnership has less than one tenth the chance of being audited when compared to an individual filing Schedule Cs or Schedule Es. You will get a K1 from the LLC which says “investment” which the IRS sees every day associated with standard investments.
Get The Language Down
Dealer property is property you hold for sale to buyers in the ordinary course of a trade or business (IRS Code section 121(a)(1)).
If you are a really active real estate investor and you are doing a number of sales a year, that tends to look more like a dealer than an investor. In a court case, S&H, Inc., there was only one sale, and the court held that S&H was a dealer. The paperwork showed that they were basically wholesaling the property, because they had a third party buyer lined up before they acquired the property. Yet, in the Nathan Goldberg case, 90 properties were sold in the same year. Goldberg had acquired the properties as rentals, but suddenly the law changed, so he sold all the properties rather than renting them. Goldberg was determined by the courts to be an investor. However, it is worth noting that the tax court said he was a dealer, but the higher court said he was an investor.
Most of the real estate investors that are doing flips are reporting their taxes as real estate investors. It is clear that the IRS will consider a flip as a dealer transaction. The flipping machine some “real estate investors” have going will definitely be considered a dealer function when the auditor catches up with them. That is one reason people say to have one LLC for flip properties and one for hold properties.
Is the real estate investor using the sale as a cash flow generation? If you are using the sale to contribute to cash flow, so you can buy more properties, then you will be classified as a dealer. If in fact you are using the money from the sale to turn around and buy another property, then that looks like a dealer. Obviously, if you have held the property for years and rented it before you decide to sell it, then it wouldn’t be a dealer sale, even if you used the money to buy more real estate.
The courts will also look at where you get your living income. If you have a day job and flip a couple of houses a year, that’s different than using cash generated from real estate sales to buy food. How are you making your living? If you make your living buying and selling properties, you are going to be tagged as a dealer. If you make your living from rental income, that’s different, and you will be considered an investor. This discussion is implying that the dealer status is tagged on you, when it should be on a deal-by-deal basis, but everyone, including the IRS, tends to look generally at the person’s actions when the judgment is made.
Making your money off real estate sales is only one factor. How much time you spend in the acquisition and sale of properties is also a factor. If you are spending all your time buying and selling real estate (fixing them up for sale), then the IRS will say you are looking and smelling like a dealer.
The courts tend to zero in on the sales efforts a taxpayer makes. Do you advertise to buy properties? Do you aggressively advertise to sell properties? Passive real estate investors just rely on their favorite real estate agent to find them properties or sell their property. They can look around for properties, but they don’t send out postcards, put up billboards, and do all the stuff I am watching people do to find and sell properties.
Set up an LLC to do the “dirty work.” If you have a separate entity that sends out the post cards, advertises to sell the properties, and so on, then you are removing those activities from the property. Yes, the IRS could say it is all you, but you are dressing up the deal differently and making it so you aren’t the “low hanging fruit” the IRS is looking for. They will have to tie a bunch of entities together to paint the full picture, and the standard IRS auditor probably won’t immediately see the big picture.
I am getting seven or eight postcards a week from people wanting to buy my properties. The people sending the cards could be investors if they want to buy my units and rent them, but if they sell them soon after they buy them, the IRS will certainly consider them dealers.
Note that just because your actions carry some of the attributes of a dealer doesn’t mean your property(ies) are dealer properties. This is a totally subjective call by the IRS. That’s the scary part. It’s your job to shore up your position as an investor rather than a dealer.
Dealer Taxation
Believe it or not, there is some good news if a property is held to be a dealer property. As a dealer, you lose the capital gains treatment of a sale. (We may lose capital gains treatment on everything if Biden does away with capital gains.) If you are not an investor with capital gains treatment, that means you are a “business.” The business tax laws now apply to you.
For example, the real estate selling expenses, commissions, legal fees, advertising and all the other expenses will be considered tax deductible business expenses. That lowers your adjusted gross income by the full amount of those expenses. On the other hand, expenses associated with an investment property are deducted from the sales proceeds. That means you only get “capital gains” tax treatment for the expenses – a lesser amount of tax savings.
Losses associated with a dealer property are not limited to $3,000 as they are in an investment property. The losses are ordinary income losses, and the entire amount of the loss can be deducted to offset
other ordinary income. The losses in a dealer property are treated just like any other business loss. The entire loss can be used immediately to offset ordinary income, or the loss can be carried forward as a net operating loss.
Dealer vs Professional
There is another IRS classification for real estate investors called a “professional.” It has nothing to do with whether or not your deal is tagged as a dealer transaction. A professional is someone who meets a number of criteria and qualifies to take the depreciation of their property and use it to offset ordinary income. That is a big advantage.
The rental income is always passive income, but the depreciation and other “losses” associated with real estate can be used to offset ordinary income. In our Tax Summit, which we do three times a year, we spend about 30 minutes on the tax professional designation, how you can meet the criteria, what it means to you for tax purposes, and who can qualify. If you have a number of rental units, and don’t have a day job, you should look into becoming a real estate professional.
The IRS will definitely play a bigger role in your life in the Biden administration. I have always maintained that the IRS is your biggest asset protection threat. I am now afraid of what is coming down the pike at us with the government using the IRS openly as a political enforcer and wealth redistribution tool. Unfortunately, the target is not the super wealthy, it is the upper middle class – the backbone of America which the establishment wants to reshape.
I like the America I grew up with. I have the background to compare. I have lived mainstreamed in the general population of Pakistan, Turkey, and Canada for at least a year each. I wish those who want to reshape America had the experiences I have had. Let them live mainstreamed in the population (not on a military base or in an American enclave) in Pakistan for a year, then tell us how we need to reshape our country. The USA is a great place – even today. ■
