One of the most popular ways that both beginning and experienced real estate investors choose to generate cash flow for their real estate investing is through a quick sale or â flipâ of a property. These transactions often generate the income that an investors lives off of while building a portfolio of â holding propertiesâ to generate future wealth. The Internal Revenue Service may determine that you are a real estate â dealerâ if you buy and flip properties based upon what they determine your intent was when you purchased the property. The factors used by the Internal Revenue Service to determine â dealerâ status are as follows:
â ˘ Number, Substance and Continuity of Sales â the more sales are made over a period a time, the more likely a sales â intentâ exists.
â ˘ Extent and Nature of Efforts to Sell Property â the more constant and intense the sales and marketing effort, the more likely sales â intentâ exists.
â ˘ Taxpayer Purpose for Acquiring, Holding and Selling Property â expressed â intentâ via written and oral communication.
â ˘ Ordinary Business of the Taxpayer â Taxpayers whose primary business is real estate such as a broker or developer have a tougher burden of proof.
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â ˘ Use of a Business Office for Sales â gives appearance of an business and not an investment.
The largest concern that a real estate investor who does a lot of â flipsâ has is that the laws related to â dealerâ status are vague and the determination of intent is subjective with no clear cut criteria. This is a heavily litigated area of tax law and court opinions are often inconsistent and vary from judge to judge.
How does â dealerâ status hurt the real estate investor?
If the Internal Revenue Service determines that you are a real estate â dealerâ , you can lose the following tax-saving benefits:
â ˘ Depreciation â rental properties held by a real estate â dealerâ are not allowed a deduction for depreciation.
â ˘ Rental Income â rental income from properties held can be determined to be ordinary income subject to self employment tax.
â ˘ Installment Sales â â dealersâ who sell property using the installment method may be forced to report the whole gain in the year of sale instead of deferring gain until actual dollars are received.
â ˘ Tax Free Exchanges â â dealersâ are not allowed to do Section 1031 exchanges with properties sold.
Tax Planning Considerations
There are several tax planning considerations and strategies that one can use to manage the implications of the â dealerâ status. They are as follows:
â ˘ Use of Multiple Entities for the Different Types of Real Estate Investing â A good strategy is to use a separate business entity (usually a C or S Corporation) to â flip propertiesâ and other business entity (usually an LLC or group of LLCâ s) to hold rental properties. Another entity could be set up to deal with properties sold on the installment method.
â ˘ Use of the Cash Basis of Accounting â Using the cash basis of accounting for the â dealerâ entity helps offset the profits because deductions can be taken for all expenses paid prior to year end and lower both the income and self-employment tax that will be due on the taxable income.
â ˘ Use of Lease/Option Instead of Installment Sale â The loss of the installment sale deferral can be eliminated by using a lease/option instead. The primary issue here is â when did the sale occurâ or â constructive ownershipâ . The lease/option agreements must be prepared properly to ensure that the lease/option will not be determined to be a constructive sale. Consult a real estate attorney to ensure that the agreements you are using conform to the proper standards to avoid this issue.
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Are you a "dealer"?