Purchasing real estate assets? This post explains what you need to know about the important distinction between real estate investor and dealer for tax purposes.
A real estate developer is taxed differently than a real estate investor. Real estate investors purchase real estate with the intention of holding properties and gaining financial return. Typically, real estate dealers acquire and sell real estate as part of their everyday business.
A real estate professional who is involved in buying real estate with the intention of selling for a profit in a short time frame, or flipping is usually considered a dealer. Contractors and builders who build houses and commercial structures, and subsequently sell the finished property to customers are also considered dealers.
A question that arises often is whether a real estate developer who purchases properties (sometimes raw land or an outdated property) and makes improvements should be considered an investor or a dealer. Real estate developers are usually treated as dealers by the IRS because they are in the business of buying and selling real estate. However, if the developers work on individual and sporadic long-term projects, they may be able to take a position they should be taxed as investors.
Why does it matter to real estate professionals?
When a real estate investor sells property that has been owned for more than one year, gain on the sale is taxed at the favorable long term capital gains rates, currently 15% or 20% depending upon income (plus the 3.8% net investment income tax, if applicable).
When real estate dealers sell their properties, those properties are considered inventory and any gains are taxed at the dealers’ ordinary income tax rates. Currently, Federal ordinary income tax rates can be as high as 39.6%.
The Internal Revenue Code offers general guidelines regarding activities that reach the level of a trade or business. However, Internal Code does not provide specific guidance regarding real estate activities. Consequently, court cases have been the primary source for defining what level of activity determines a trade or business in real estate development and, therefore, the nature of the income.
The main factor in determining if a taxpayer is a real estate investor or a dealer is his or her intent with respect to the property. The mere fact that an individual holds a piece of property for a short period of time does not automatically cause him or her to be a dealer. Often an individual purchases real estate with the intent of holding it for investment purposes, but sells it earlier due for financial or economic reasons.
Consider the Winthrop Factors
A case often cited when determining dealer vs. investor status is United States v. Winthrop. In determining whether the gain from sales was ordinary or capital in nature the court relied on a series of facts and circumstances in the Winthrop case. These have become commonly referred to as the “Winthrop Factors.”
Subsequent court cases have enumerated the following 9 Winthrop Factors:
- The purpose for which the property was initially acquired
- The purpose for which the property was subsequently held
- The extent of improvements made to the property
- The number and frequency of sales over time
- The extent to which the property has been disposed of
- The nature of the taxpayer’s business, including other activities and assets
- The amount of advertising/promotion, either directly or through a third party
- The listing of the property for sale through a broker
- The purpose of the held property at time of sale; the classification as an investor or dealer is determined on a property-by-property basis.
Talk to your tax professional
With such a wide disparity between the maximum capital gains tax rate of 20% (plus the net investment income tax 3.8%) and the tax rate on ordinary income of 39.6%, it is important to consult your tax advisor regarding newly acquired real estate assets and established investments.
Non-U.S. persons are subject to income tax only on their U.S. source income (income earned within the United States). According to the Internal Revenue Service, most types of U.S. source income paid to a 
Many pass-through entities, including limited liability companies, are often tempted to cash out on the appreciation of their real estate holdings through refinancing. The members then have the discretion to use these funds as they see fit, including investing in other properties and projects or for personal use. It is often assumed that interest on the new mortgage is fully deductible for income tax purposes; however, that is not necessarily the case.
the expenditures in one of four categories:
It all comes down to passive and non-passive activities related to property.
Any real property development, redevelopment, construction, reconstruction , acquisition, conversion, rental, operations, management, leasing or brokerage trade or business qualifies as real property trade or business.
First, consider that your rental property (like many other businesses) may not yield positive cash flow at first. Improvements to the property, tenant issues, and other expenses may end up putting you in the negative column. If you do end up with a rental loss, you are subject to complex IRS rules regarding how much of your rental losses you may deduct from other income you earn during the year.
The Internal Revenue Code, the Internal Revenue Service (IRS), and taxpayers have been in conflict over whether expenditures on tangible property are deductible now, or must be capitalized and recovered through depreciation over time. The distinction between deductible repairs and capital improvements has been determined largely through case law and is based upon facts and circumstances.
