Real estate investing can be a lucrative business but determining whether a gain or loss on the sale of the property is considered capital or ordinary is not always straightforward. Actions taken with respect to real property can impact gains and losses, and the classification of the property can have a significant impact on the taxes owed on the sale.
Understanding Property Classifications
Real estate investors need to understand the difference between holding real estate for investment purposes versus holding it as dealer property. Real estate deemed held for investment is subject to favorable capital gain tax rates, while real estate treated as dealer property is subject to less favorable ordinary income tax rates.
The issue of dealer versus investor classification has been frequently litigated, and it’s important to clearly understand the difference. In this article, we’ll break down the main factors that determine the proper classification of a taxpayer as either a dealer or an investor in real estate properties.
1. The Purpose for Which the Property Was Acquired
The nature and purpose for which a property was acquired is an important factor in determining its classification. Additionally, the duration of ownership is a relevant factor. If the property is held for less than a year and a day, and the owner is actively involved in the process of buying and selling properties for profit, it is likely to be treated as inventory taxed at ordinary rates.
On the other hand, if the property was acquired with the intention of holding it for a long-term investment, it is more likely to be classified as investment property. A holder of investment property is not typically involved in buying and selling multiple properties, but rather holds the property as a long-term investment with the aim of generating income through rent, appreciation or both.
2. The Extent and Nature of the Taxpayer's Business
When determining the classification of a property, the extent and nature of the taxpayer’s business are key factors. The Internal Revenue Service (IRS) will consider factors such as the taxpayer's history of real estate transactions, the nature of the properties sold, the length of time the properties were held and the taxpayer's intentions at the time of acquisition.
The frequency, continuity and substantiality of sales is another important consideration in determining whether a property is classified as dealer or investment property. If a taxpayer regularly and consistently engages in the sale of real estate, it is likely the property will be classified as dealer property. “Engaged” in the business means:
- The taxpayer is routinely buying and selling real estate
- The activity is continuous, and
- The sales are made in the ordinary course of business
If the taxpayer is deemed to be engaged in the trade or business of real estate holding dealer property, any profit will be subject to ordinary income tax rates. However, if the taxpayer is primarily engaged in another primary profession, and only occasionally sells real estate, it is more likely that the property will be classified as investment property.
3. The Time and Effort Expended in Developing and Improving the Property
The time and effort expended in developing and improving the property is an important factor in determining the classification of the property as dealer or investment property. It is more likely that the property will be classified as dealer property if the taxpayer has made significant improvements to the property, such as subdividing land, adding infrastructure, constructing new buildings or renovating existing ones.
If only minor improvements have been made to the property, such as painting or landscaping, it is more likely that the property will be classified as investment property.
If the property has been improved for the purpose of generating income through rent, appreciation or both, capital gains tax rates could be subjected on any gains from the sale of the property.
Dealer vs. Investor Pros and Cons
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Your Guide Forward
Real estate investors need to be aware of these factors and how they can impact the classification of their property. Detailed record keeping of all transactions and intentions related to those properties will be instrumental in supporting the classification of the activity.
Consultation with a tax professional will be necessary to verify that the property is properly classified and that the taxes owed on the sale are accurate. By understanding the classification of their property, real estate investors can make informed decisions about their investments and minimize their tax liability.
To ensure that your investment aligns with your overall real estate tax planning strategy, it's important to work with experienced tax professionals who understand real estate classifications. Cherry Bekaert's Real Estate & Construction professionals understand the various factors that the IRS considers in making this determination and can provide guidance on how to properly classify a property based on its intended purpose, frequency of sales, extent of business involvement, and time and effort expended in developing and improving the property. Contact us today to learn more about how we can help.
