When it comes to real estate investing, you don’t want to be labeled a real estate dealer. Being tagged a dealer by the IRS can be a financial disaster because the tax rules will work against you.
Unfortunately, when you are involved in real estate transactions the IRS (and many inept tax preparers) may try to classify you as a real estate “dealer”.
Just say NO!
The main area of concern in real estate investing is those involved in the wholesale or flipping sector of real estate investing. Why?
Treasury Regulations Section 1.402(a)-4 defines a dealer as “a person who is engaged in the business of selling real estate to customers with a view to the gains and profits that may be derived from such sales.”
What does than mean? you are no different than the business that sells widgets. Due to the nature of the wholesale business, there are a large number of transactions and they are short-term. Which provides the ammunition to the IRS to treat the profits as ordinary income.
Why avoid the dealer label?
As a real estate dealer you’re taxed a 15.3% self-employment tax, which is added to your personal tax bracket. Also, you are subject to the highest ordinary income tax rates and possibly alternative minimum taxes (AMT). Ouch!
If that is not enough:
– profits cannot be tax deferred, they do not qualify for section 1031 tax deferral.
– You will lose the ability to defer income recognition on installment sales.
– No cost recovery through depreciation since the IRS will treat the real estate as inventory.
How to avoid being classified as a dealer?
Often investors will structure real estate deals through a single member LLC that is disregarded for tax purposes and the dealer status will flow directly to the single member of the LLC. A solution I provide for your consideration is to set an LLC that is taxed as an S Corporation. Since the wholesale activities will occur at the corporate level, the dealer status does not flow down to the owner.