A taxpayer’s activities and intentions when purchasing and selling real property are important in determining whether that taxpayer is a dealer or investor in real property. This distinction is relevant, since it determines the tax treatment of the gain on the sale of real property. If the taxpayer is a dealer in real property, the gain recognized is taxed as ordinary income. If the taxpayer is considered to be an investor in real property, then the gain recognized is a capital gain. The highest federal long-term capital gain tax rate for 2014 was 23.8% (which includes Net Investment Income Tax), while the highest ordinary income tax rate was 39.6%. It should be noted that when there is a net short-term capital gain recognized for the year, that gain is taxed as ordinary income. Additionally, dealers hold property primarily for sale to customers. Such property is considered inventory and cannot be used in an Internal Revenue Code Section 1031 exchange.
When determining whether a taxpayer is a dealer or investor in real property, all the facts and circumstances are taken into consideration. To assist in this analysis, the Tax Court has fleshed out several factors to consider. Although an individual who is a broker or developer of real property most likely will be considered to be a dealer in real property, the Tax Court has shown that this label may be avoided if certain actions are taken. That being said, when there is a net loss for the year on total sales of real property, the taxpayer may want to be considered a dealer of real property.
To benefit from the reduced capital gain tax rates, a taxpayer must establish that the real property sold was a capital asset. The definition of a capital asset includes real property not held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. The definition of the term “business” has been established in case law. The Tax Court in Robert L. Adams adopted the following definition of the term business: “busyness (sic), it implies that one is kept more or less busy, that the activity is an occupation. It need not be one’s sole occupation, nor take all his/her time. It ordinarily is implied that one’s own attention and efforts are involved.” (Snell v. Commissioner, cited in Robert L. Adams).
With this definition in mind, there are several factors that the Tax Court has utilized when determining whether a taxpayer is a dealer or an investor in real property. These factors include: 1) the purpose for which the property was acquired; 2) the purpose for which the property was held; 3) the improvements, if any, made to the property; 4) the extent and substantiality of the sales; 5) the nature and extent of the taxpayer’s business; 6) the extent of advertising and promotion of the sale of the property; and the listing of the property for sale directly or through a broker. (Robert L. Adams)
When applying these factors to the Adams case, the Tax Court found that Mr. Adams was an investor in real property. At the outset, Mr. Adams was a partner in an accounting firm where he worked 6 days a week servicing clients. The income from his accounting practice made up a majority of his yearly income. He purchased 11 waterfront properties, which he sold over the course of four years. Mr. Adams purchased the properties with the intention of realizing a gain on their appreciation. While Mr. Adams held the properties, he did not subdivide or make any improvements upon them. Additionally, Mr. Adams never advertised the properties for sale and did not maintain a separate office facility to further his real estate interests. Based on these facts, the Tax Court concluded that Mr. Adams was not a dealer of real property.
Mr. Adams’ real estate activities were essentially passive in nature. The properties were purchased by Mr. Adams, appreciated in value, and were then sold to realize the gain on appreciation, without any real effort on his part. It can be inferred from this that if non-real estate professionals who frequently invest in real property can establish that they are passive investors in real property, they can establish that they are investors in real property, even if sales are relatively frequent.
Moreover, brokers and developers can segregate their investment and dealer properties into separate groups to avoid the dealer label. For example, in Richard H. Pritchett, Mr. Pritchett was a broker actively engaged in the brokerage business and the sole owner of a real estate brokerage firm. He purchased four properties in his own name, which he later sold. Prior to the sales, the properties were held for an extended period of time, not subdivided or developed, and the actual sales were unsolicited. The Tax Court held that Mr. Pritchett was an investor in those four properties, with the court stating that segregation of those properties was a key factor in its decision.
Developers can also segregate portions of land into separate, distinct groups. In Robert P. Walsh, Mr. Walsh, a developer of real property, segregated portions of his property into two separate and distinct categories. One portion of the land was designated to be subdivided into single-family dwelling sites to be sold to customers, and the other portion of the land was slated for no development. The Tax Court concluded that sales of property in the first category were sales made in the ordinary course of Mr. Walsh’s trade or business and subject to ordinary income tax rates; and the sale of the second category of property was considered investment property sold at capital gain tax rates. Although each transaction is viewed on a case-by-case basis, segregation of investor and dealer property may be one way to reduce the dealer designation.
However, in a loss situation, a taxpayer might want to be considered a dealer in real property. When selling real property for a loss, the taxpayer will incur an ordinary loss that can be utilized to offset ordinary income. This will produce a greater tax benefit than if the property was held for investment, causing a capital loss to be incurred.
For the most part, it’s in a taxpayer’s best interest to avoid being considered a dealer in real property, as this could subject the taxpayer to higher tax rates and limit the taxpayer’s ability to enter into a 1031 exchange. A taxpayer can avoid being labeled a dealer by appropriately segregating property, establishing passive activities, and not fully developing the property. Conversely, a taxpayer may want to be considered a dealer when there is a loss situation and tax benefits can be obtained.
The tax practitioners at Friedman LLP have extensive experience in helping taxpayers navigate the important dealer versus investor analysis process. If you have any questions, or need assistance in this area, reach out to your Friedman engagement partner or representative.