When real property is sold for a gain or loss, an important question to ask is whether the seller is a dealer or investor in real property. The ultimate resolution of the dealer versus investor question has significant tax implications given the current differences between the capital gain and ordinary income tax rates.
Tax Advantages and Disadvantages of Dealer vs. Investor Classification
The chart below illustrates the tax treatment of the sale of real property at a gain or a loss dependent on whether the taxpayer is considered a dealer or an investor.
|Gain versus Loss||Dealer||Investor|
|Gain on Sale||Gain taxed as ordinary income at the taxpayer’s ordinary income tax rates.||Subject to preferential federal tax treatment: Currently 20% maximum, plus a possible 3.8% net investment income tax, depending on whether the seller’s modified gross income exceeds the applicable net investment income tax dollar threshold.|
|Loss on Sale||Considered an ordinary loss which can offset other income items.||Considered a capital loss.|
As demonstrated above, one benefit of being considered a dealer in real property is the tax treatment of a loss on sale.
- For individual taxpayers, ordinary income will be reported on Schedule C and subjected to self-employment tax and unincorporated business tax for New York City residents.
- For the sale of real property held in a partnership, Limited Liability Company or some other pass- through entity, the income allocated to the owners will be reported on Schedule E.
Thus, taxpayers prefer to be considered investors in real property when selling real property at a gain and dealers in real property when the property is sold for a loss.
Basic Factors in Determining Dealer vs. Investor Classification – Actions and Intent
The determination of dealer versus investor hinges on many factors, but turns mainly on the intent and activities of the seller at the time of the sale. If the taxpayer purchases land with the intent to subdivide the property and sell plots to customers in the ordinary course of business, most likely that person is going to be considered a dealer. However, if the individual holds the property for several years, without any effort to promote or develop the property, that individual would probably be considered an investor.
Dealer vs. Investor According to the IRC
The starting point for determining whether a taxpayer is a dealer or investor in real property is Internal Revenue Code Section 1221 which defines what property is considered to be a capital asset, and is written in the negative. Section 1221(a)(1) states, in part, that property held by the taxpayer primarily for the sale to customers in the ordinary course of business is not a capital asset.
Most taxpayers who sell depreciable property held for more than one year that is used in their trade or business can avoid ordinary income treatment by utilizing the provisions of Internal Revenue Code Section 1231.
- Generally, if the taxpayer’s net section 1231 gain exceeds the section 1231 losses, the net 1231 gain will be treated as long- term capital gain.
- If the 1231 property is sold for a loss, the loss will be considered an ordinary loss (not a loss from the sale of a capital asset).
Investors in real property, who hold property as an investment and not for sale to customers, can utilize these beneficial provisions. However, if the property owned by the taxpayer is treated as property held for sale to customers, the Section 1231 tax treatment will not apply pursuant to IRC 1231(b).
If a taxpayer is considered to be a dealer in real property, the provisions of Section 1231 will not be applicable. This puts added importance on being labeled an investor rather than a dealer.
How the Courts Distinguish Between Dealer vs. Investor
When determining whether a taxpayer is acting as a dealer or an investor in real property, various courts, including the United States Tax Court in Frank H. Taylor & Son case have considered several factors. No one factor is dispositive and each factor should be weighed in the analysis. These include:
- the purpose for which the property was acquired;
- the purpose for which the property was held;
- improvements, and the extent of the improvements made to the property by the taxpayer;
- the frequency, number and continuity of sales;
- the extent and substantiality of the transactions;
- the nature and extent of the taxpayer’s business;
- the extent of advertising to promote sales, or the lack of advertising; and,
- the listing of property for sale directly through brokers.
It is important to note that some of these factors are applied to the particular property being sold and not to the taxpayer’s activities. The factors are analyzed separately for each property sold.
Situations When a Taxpayer Can be Considered Both a Dealer and Investor
When making the analysis, a taxpayer can be considered both a dealer and investor in real property based on factual circumstances. In taking the Ridgewood Land Co. case for example (as highlighted in Robinson: Federal Income Taxation of Real Estate Part V Paragraph 17.14), the taxpayer, a land developer, purchased a 500-acre tract of land for purposes of developing the land into residential homes for purchase by customers. The taxpayer was successful in developing and selling 325 acres to a residential builder. It then purchased a nearby 80 acre parcel for the same purposes. Subsequently, the government authorized a condemnation of that land to use for fill dirt in a highway construction project.
After the condemnation, the taxpayer decided that it could not develop the land and held it for investment. The taxpayer then sold the 80 acres to a contractor who was going to use the land in the highway project. The gain on the sale was taxed as capital gain since, at the time of sale, the taxpayer was an investor in the property.
The ultimate determination as to whether a taxpayer is a dealer or investor in real property is based on all the facts and circumstances—and has serious tax implications. Therefore, it is imperative that the taxpayer document his/her intentions and actions surrounding the purchase and sale of the property.
Should you have any questions or need guidance on the tax implications of a purchase or sale of property, please contact a Friedman LLP professional for assistance.