Here are a few articles/information/links about dealer status in real estate. This is a very long page, with full articles from Greg Boots, Randy Swad, Michael Hauser, and Richard Frunzi, all of them licensed and very smart attorneys on the subject. Please take some time to read each article so that a clearer picture emerges as to the proper, proven, and legal way to structure your business to avoid the dreaded dealer status. Not all of the advice is the same, so read each and decide for yourself.
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The latest I have read is from Charles Perkins, a CPA based in Seattle that writes occasional articles for BawldGuy.com. He basically says to run buy and holds in one entity, and the flip transactions in another. Read more <here>.
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This, from an article for the Bigger Pockets Blog by Greg Boots, attny:
When most investors think about business planning for their real estate investments, their main focus tends to be strictly on asset protection. However, there is a genuine need to also focus on potential adverse tax consequences depending upon the type of real estate transactions that you have targeted for your investing strategy. Wholesaling properties falls within this realm. Typical investors will often enter into a wholesale in their own name since they are not concerned about asset protection because of the short holding period. Unfortunately, they are oblivious of the severe tax consequences that loom in the shadows.
Real Estate Wholesaling & Dealer Status
To give you a little background, a wholesale transaction is a deal entered into for profit in which title will transfer into the investor’s name and then be sold within a twelve month period. Investors generally believe that the gain on the property will only be treated as short term capital gain and thereby taxed in their individual tax brackets. The investors would be correct if it wasn’t for the “dealer” classification. A “dealer” in real estate is defined in Treasury Regulations Section 1.402(a)-4 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. There is no magic number on the number of transactions you have to do before getting classified as a dealer. Unfortunately for investors this is strictly an intent based test and therefore the burden will be placed upon investors to prove that they are not dealers.
Implications of Dealer Classification
If the investors do get classified as dealers, there is a litany of negative tax consequences that will follow:
- The income earned from the investment will be treated as earned income and thus subject to a 15.3% self-employment tax that will be added on to their own personal tax bracket;
- Investors will no longer be able to capture the depreciation on their rental properties because the rentals will be view as inventory by the IRS and inventory is not subject to depreciation;
- Investors will no longer be able to enter into 1031 exchanges; and
- Investors will lose the ability to defer income recognition on installment sales.
These are tax consequences that generally want to be avoided at all costs.
It is clear that investors do not generally want to be classified as dealers, but what business entity should they use for the wholesales? If the wholesale occurs through a limited partnership, the dealer classification will attached to the general partner. If the investor is the general partner there is no tax benefit in using a limited partnership. Often investors will structure the deal through a single member LLC that is disregarded for tax purposes. However, since the LLC has no separate tax structure the dealer status will flow down directly to the single member of the LLC. Wholesale transactions are one of the few times that we want to have real estate within our corporations.
Implications & Protection
From a tax standpoint, a corporation, or an LLC that has elected to be taxed as a corporation, is perfectly suited for an investor’s wholesale activities. Since the sale of the wholesale occurs out of the corporation, the dealer status will not be attached to the owner of the corporation or the member of the LLC that is taxed as a corporation. Whether or not you use a “C” or “S” corporation is an issue that I would raise with your accountant or attorney because there are a variety of factors that should be addressed when determining the best tax structure. It is very important that title of the wholesale be immediately transferred into the corporation and that the sale occurs through the corporation. Many investors will take title personally, rehab the property, place the property on the market and then transfer title to the corporation immediately before sale. This would be viewed as a tax motivated transaction by the IRS and would be disallowed on audit.
The dealer tax classification is truly a trap for the uninformed investor. Thankfully, this pitfall is easily avoided through proper business planning. There is not a one size fits all solution for all investors, each transaction should be entered into in an informed manner, not only in terms of asset protection, but also in regard to the tax ramifications.
Mahalo Greg for this easy to understand explanation!
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Another great article and rather laborious explanation by Randy Swad, this has a few case studies on IRS rulings. DOC, TAXES-MAG Taxes–The Tax Magazine, October 2002, Understanding Dealer Status on the Sale of Real Estate
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Understanding Dealer Status on the Sale of Real Estate
©2002 R. Swad
By Randy Swad, Ph.D., CPA, CBA, is a Professor of Accounting at California State University, Fullerton.
Randy Swad explains classification as a dealer of real estate pursuant to Code Secs. 1221(a)(1) and 1237 .
Introduction
Several tax benefits are available to individual investors in real estate when property is sold or exchanged. If the property has been held more than one year, any gain recognized is taxed at the reduced rate for long-term capital gains.
1 Alternatively, realized gains can be deferred using the installment sale rules of Code Sec. 453 or the like-kind exchange rules of Code Sec. 1031 . These benefits are not available when a taxpayer is considered to be a dealer with respect to the property sold.
2 A taxpayer is a dealer if the property sold was held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business.
3 Any gain on the sale of dealer property is taxed as ordinary income
4 and, for an individual taxpayer, is also subject to the tax on self-employment income.
5 Classification as a dealer is a risk for any taxpayer who engages in multiple sales of real estate over a relatively short time period. There are two possibilities for avoiding dealer status. The first possibility is to be able to show that, pursuant to Code Sec. 1221(a)(1) , the property was not held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. As this article will demonstrate, this approach to avoiding dealer status is highly uncertain. The second approach, which is highly certain but very narrow in application, is to qualify for capital gain treatment under Code Sec. 1237 . This article discusses how dealer status can be avoided under these two alternative approaches.
Dealer Status Under Code Sec. 1221
Under Code Sec. 1221(a)(1) , the definition of a capital asset excludes property held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. To apply this provision in a factual setting involving the sale of real estate, two questions must be answered. First, was the taxpayer in the real estate business? And, second, was the property held primarily for sale to customers in the ordinary course of that business? If the answer to either question is no, then Code Sec. 1221(a)(1) does not apply and capital gain treatment would be allowed. Unfortunately, no guidance is available in the Code or the regulations on how to determine the answers to these questions in a factual setting. Consequently, this issue has been litigated in hundreds of cases that date back to the 1930s.
6 In deciding these cases, the courts generally consider a number of factors that differ somewhat from case to case. The number of factors considered by the courts has ranged from four 7 to 14. 8 In A.B. Winthrop, 9 the Fifth Circuit considered seven factors that were mentioned most often in prior cases. The court referred to these factors as the “seven pillars of capital gain treatment.” These seven factors have come to be known as the Winthrop factors:
1. The nature and purpose of the acquisition of the property and the duration of ownership
2. The extent and nature of the taxpayer’s efforts to sell the property
3. The number, extent, continuity and substantiality of the sales
4. The extent of subdividing, developing and advertising to increase sales
5. The use of a business office for the sale of the property
6. The character and degree of supervision or control exercised by the taxpayer over any representative selling the property
7. The time and effort the taxpayer habitually devoted to the sales
The Winthrop factors are not strict tests that must be passed or failed, and, generally, no one factor is determinative. A court typically will base its decision on the factors relevant to the case at hand. How these factors are applied and how much weight is given to each factor, however, has not been historically consistent within the judicial system.
Purpose of Acquisition and Duration of Ownership
If the property is acquired primarily for the purpose of reselling, dealer status is indicated. The Supreme Court in W. Malat 10 stated that “primarily” means “of first importance” or “principally.” Thus, if there is more than one purpose, only the primary purpose should be considered. The court also stated that the purpose of Code Sec. 1221(a)(1) is to differentiate between profits and losses arising from the everyday operation of a business and the realization of appreciation in value accrued over a substantial period of time. Property may be acquired and held for investment, but capital gain treatment can, nevertheless, be denied if the property is subdivided and lot sales are frequent and substantial over an extended time period. 11 A short holding period is also an indication of dealer intent. Generally, the longer the period of ownership, the more likely it is that the property will be characterized as investment property. In L.F. Paullus, the Tax Court ruled that property was held as an investment, noting that the four-year holding period tends to support the conclusion that the property was held for investment purposes.
12 However, some cases have resulted in ordinary income treatment despite a very long holding period.
13 Number, Extent, Continuity and Substantiality of Sales. This factor generally is considered to be the most important factor.
14 Where property sales are frequent, continuous and substantial, dealer
status is highly probable. In W.D. Little,
15 the taxpayer bought houses at foreclosure sales and rented them for a period of time prior to selling them. The Tax Court denied capital gain or Code Sec. 1231 treatment on the resulting gains. In the three years at issue, the taxpayer completed 163 purchases and 321 sales of real estate. The taxpayer argued that the properties were held primarily for rental purposes, but the court concluded that the taxpayer was engaged in the business of buying and selling real estate. Where sales are not frequent, dealer status is not likely even where other factors indicate dealer activity. In G.V. Buono, 16 an S corporation acquired a tract of land for the purpose of selling the entire tract as soon as the local municipality approved the corporation’s application to subdivide the property. The corporation acquired no other property and was engaged in no other activity. The IRS argued that the gain on the eventual sale of the property should be taxed as ordinary income, because the property was held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. However, the court allowed capital gains treatment because of the lack of frequent sales and the isolated nature of the transaction.
The court concluded that the taxpayer’s activities did not rise to the level of a trade or business. The level of activity required to indicate dealer status is not clear. However, in M. Hancock, 17 the Tax Court considered eight sales over a two-year period to be frequent, regular and substantial.
Extent of Subdividing, Developing and Advertising to Increase Sales
Development activities such as subdividing, grading, installing utilities and building roads are viewed by the courts as business activities.
Thus, when a taxpayer engages in development activities, dealer status is more likely. In G.A. Bush, 18 the taxpayers acquired several contiguous properties for the purpose of constructing an apartment building. After obtaining demolition and building permits, arranging financing and negotiating a construction contract, the taxpayers sold the property. The Tax Court denied capital gain treatment, because, in the court’s view, the gain was attributable to the real estate development activities undertaken by the taxpayers prior to sale. Development activities, however, do not always result in dealer status. In V.H. Huey, 19 the taxpayer built a road through a parcel of unimproved land prior to sale and capital gain treatment was allowed. The court placed greater weight on other factors, such as the purpose for holding the property and the frequency of sales.
Sales Activities and Use of Business Office
The other Winthrop factors involve the procedures and efforts used by the taxpayer in selling the property and use of a business office.
Aggressive and active sales efforts and using a business office are considered by the courts to be more consistent with a business activity rather than an investment activity. In denying capital gain treatment in Little, 20 the Tax Court noted that the taxpayer exercised close and direct supervision and control over all his representatives involved in the sales of his properties. In J.D. Byram, 21 the Fifth Circuit allowed capital gain treatment, noting the taxpayer made no personal effort to initiate sales, buyers came to him, he did not advertise, he did not have a sales office and he did not enlist the aid of brokers. However, the Third Circuit, in In re Jersey Land & Development Corp., 22 cautioned against placing too much reliance on sales activities, noting that they do not focus on the ultimate issue of a taxpayer’s motivation in holding a particular piece of property.
Avoiding Dealer Status
Strategies for avoiding dealer status under Code Sec. 1221 are difficult to formulate. There are hundreds of cases involving the Code Sec.
1221(a)(1) issue and each case turns on its own specific facts and circumstances. The Fifth Circuit has stated that reconciliation of the cases dealing with Code Sec. 1221(a)(1) is fruitless. 23 The same court commented on the problem in another case with the following quote: “If a client asks you in any but an extreme case whether, in your opinion, his sale will result in capital gain, your answer should probably be, ‘I don’t know and no one else in town can tell you.’” 24 Nevertheless, a review of the cases can provide hints of strategies that may be used to improve the chances of prevailing in an IRS challenge based on Code Sec. 1221(a)(1) . Some of these strategies are suggested below.
However, practitioners searching for a solution to a specific problem are urged to read the cases cited and carefully compare the facts of the cases to the problem at hand.
Avoid Being in the Real Estate Business. The courts have often allowed capital gains treatment when the taxpayer was not considered to be in the real estate business. Neither the Code nor the regulations contain a definition of the term “trade or business,” but, in C.P. Snell, 25 the Fifth Circuit provided a frequently cited definition of the word “business”: The word, notwithstanding disguise in spelling and pronunciation, means busyness; 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 time. It may be only seasonal, and not active the year round. It ordinarily is implied that one’s own attention and effort are involved, but the maxim qui facit per alium facit per se applies, and one may carry on a business through agents whom he supervises.
In determining whether the taxpayer is in the real estate business, the courts generally consider the time and effort spent on real estate activities as compared to the time and effort spent on other activities. In J.L. Van Drumen, 26 the taxpayer, a physician, was the co-owner of a large parcel of land. The land was subdivided into residential lots and extensive improvements were made consisting of streets, street signs, sidewalks, curbs and storm sewers. The lots were also landscaped. Over a six-year period, 93 lots were sold, but the Tax Court allowed capital gain treatment. The court concluded that the taxpayer was not in the real estate business:
The active pursuit of his practice of medicine, coupled with the complete absence of “busyness” on his part in connection with the development and sale of the lots in the Munster property, indicate the liquidation of a capital asset by a man who, at most, had attempted to put his savings to work by investment in real property while following his profession in a normal way.
Thus, where a taxpayer is employed full-time in an occupation other than real estate, an absence of “busyness” in the real estate activities would help to avoid dealer status.
27 Clearly Separate Investment Activities from Dealer Activities. A real estate dealer may hold certain property as an investment while at the same time holding other property for sale to customers. In N.A. Farry, 28 the taxpayer was a licensed real estate dealer who built and sold houses, reporting the profits as ordinary income. The taxpayer also owned houses that were rented to tenants and eventually sold. The Tax Court allowed capital gain treatment on the sale of the rental homes, noting that the taxpayer maintained separate records for his different activities. The court asserted that a dealer also can be an investor where the facts show clearly that the investment property is owned and held as an investment for revenue and speculation. 29
Using entities to separate investment activities from dealer activities should be helpful in documenting the separation of the activities.
However, the use of entities will not insulate the taxpayer from dealer status where other strong dealer characteristics are present. In Little, 30 the taxpayer used a corporation for properties he bought and sold quickly. He took personal ownership of properties that he held longer term as rentals. Nevertheless, the Tax Court denied capital gain treatment on the rental properties, noting that the operation of a corporation as a dealer does not automatically relieve the taxpayer of being a dealer in an individual capacity.
Was There a Change of Purpose? Even where property is acquired for the purpose of resale, capital gain treatment may be allowed if a change of purpose can be documented. In Maddux Construction Co., 31 the taxpayer was a builder of single family homes. The corporation purchased a parcel of land for the purpose of building homes, and approximately 31 months later, the property was sold in bulk for commercial use. The Tax Court allowed capital gain treatment noting that (1) the original purpose was abandoned soon after the property was acquired, (2) the only improvements made were to extend water lines to the property and (3) the property was not advertised for sale nor listed with a broker.
32 Was There a Liquidation Intent? Where property was held as an investment and then sold for the purpose of liquidating that investment, capital gain treatment has been allowed despite a large number of sales and extensive sales activities. In J.E. Heller Trust, 33 the taxpayer sold 169 duplexes over a four-year period using an association as sales agent and using extensive newspaper and radio advertising. The taxpayer was the president of the association and obtained a real estate broker’s license during the period the duplexes were being sold.
Nevertheless, the Ninth Circuit allowed capital gain treatment, noting that the property was held as an investment until shortly before the time of sale and the sale was prompted by a liquidation intent.
34 Extend the Holding Period. A short holding period is an indication of dealer status, but there is no clear authority on how long the holding period should be to indicate investor intent. However, in Byram, 35 the Fifth Circuit provided some guidance on this issue. The IRS argued that frequent and substantial sales combined with relatively short holding periods indicated an intent to hold the properties for sale.
However, the court allowed capital gain treatment, noting that the holding periods exceeded the threshold for long-term capital gain treatment. Thus, holding properties for more than one year may be a positive factor in avoiding dealer status.
Sale to Controlled Corporation. Where land is to be subdivided and the individual lots are to be sold to customers, the dealer problem may be avoided, to some extent, by using a corporate entity to develop the property. The land can be acquired by an individual taxpayer and held for a period of time. Prior to initiating development activities, the land is sold to a corporation owned by the taxpayer. Any gain realized on the sale to the corporation may be taxed as a capital gain. The corporation would then develop the land, sell the lots and be taxed on the resulting profits. In R.H. Bramblett, 36 a partnership sold a parcel of land to a related corporation. The ownership interests in both entities were identical. The partnership owned the land for three years prior to selling it to the corporation, which then developed the land and sold it to third parties. The Tax Court denied capital gain treatment on the sale of the land to the corporation, concluding that the partnership was in the business of selling land. The Fifth Circuit, however, reversed the Tax Court, asserting that the activities of the corporation should not be attributed to the partnership. The court noted:
l Liability protection was a major business reason for having the corporation develop and sell the land.
l There was no substantial evidence that the transaction was not at arm’s length and legal formalities were not observed.
l The partnership bought the land as an investment, hoping its value would appreciate.
Thus, Bramblett provides some guidance for using a controlled corporation in this manner. To avoid dealer status on the sale of the property to the corporation, taxpayers should employ the measures implied in the decision:
l Have a business reason for using the corporation, and liability protection is a valid reason.
l Conduct the transaction at arm’s length. The selling price should be based on fair market value. An independent appraisal could be used to support the value.
l Observe the normal legal formalities. Proper form should be used in drafting all documents. Any debt instruments should contain the commonly required commercial terms regarding interest rates and payment dates.
l Be able to show that the property was acquired as an investment prior to selling to the corporation. The purchase contract should not indicate the taxpayer’s intent to subdivide or develop the property. The property should be reported as an investment on any financial statements or tax returns prepared by the taxpayer. The taxpayer should not conduct any kind of development activities prior to selling to the corporation. The longer the holding period, the more likely it is that an investment intent will be accepted.
Dealer Status Under Code Sec. 1237
Code Sec. 1237 is a safe harbor provision that assures a taxpayer, other than a C corporation, will receive capital gain treatment on the sale of subdivided lots from a single tract of land. 37 The provision was enacted in 1954 to enable an individual to subdivide a parcel of land and sell the lots without being considered a dealer. The intent was to provide relief from the dealer status problem where subdividing may be the only way to dispose of a tract at a reasonable price for an individual who is not otherwise in the real estate business. 38 Code Sec. 1237 , however, contains extensive requirements pertaining to (1) the dealer status of both the tract and the taxpayer, (2) limitations on improvements to the tract and (3) the holding period of the tract. Additionally, complete capital gain treatment is limited to the first five lots sold from the tract.
Upon the sale of the sixth lot, part of the gain may be taxed as ordinary income.
Dealer Status Rules
Code Sec. 1237 contains dealer restrictions for both the tract and the taxpayer. The tract will not qualify under the statute if any part of it has ever been held by the taxpayer for sale to customers in the ordinary course of a trade or business (unless the tract was covered under Code Sec. 1237 at that time). 39 The tract also will not qualify if the taxpayer holds any other real property for sale to customers in the ordinary course of a trade or business in the year in question. 40 If there is no substantial evidence that a taxpayer holds any other real property primarily for sale to customers in the ordinary course of a trade or business, the taxpayer will not be considered a real estate dealer with respect to the subdivided tract as a result of subdividing the tract into lots and engaging in advertising, promotion, selling activities or using sales agents to sell the lots. 41 If there is other substantial evidence that the taxpayer held other real property for sale to customers in the ordinary course of a business, then the activities in connection with the subdivided tract and the other property will be considered in determining the purpose for which the taxpayer held both the subdivided tract and any other real property. Other evidence may consist of any of the following:
l Selling activities in connection with other property in prior years during which the taxpayer was engaged in subdividing or selling activities with respect to the subdivided tract
l Intention in prior years (or at the time of acquiring the property subdivided) to hold the tract primarily for sale in the taxpayer’s business
l Subdivision of other tracts in the same year
l Holding other real property for sale to customers in the same year
l Construction of a permanent real estate office that could be used in selling other real property
If the only evidence of the taxpayer’s purpose in holding real property consisted of not more than one of the following in the year in question, such fact would not be considered substantial other evidence:
l Holding a real estate dealer’s license
l Selling other real property that was clearly investment property
l Acting as a salesman for a real estate dealer, but without any financial interest in the business
l Mere ownership of other vacant real property without engaging in any selling activity whatsoever with respect to it
If more than one of the above exists, the circumstances may or may not constitute substantial evidence that the taxpayer held real property for sale in the taxpayer’s business, depending upon the particular facts in each case. 42
Substantial Improvements
A tract will not qualify under Code Sec. 1237 if an improvement is made to the tract that substantially enhances the value of the property. 43 Among the improvements considered substantial are shopping centers, other commercial or residential buildings and the installation of hard surface roads or utilities such as sewers, water, gas or electric lines. A temporary structure used as a field office; surveying, filling, draining, leveling and clearing operations; and the construction of minimum all-weather access roads, including gravel roads where required by the climate, are not substantial improvements. 44
The increase in value to be considered is only the increase attributable to the improvements. Changes in the market value of the tract, not arising from improvements made by the taxpayer, are disregarded. An increase in value is measured by the difference between the value of the tract, including improvements, and an appraisal of its value if unimproved at that time. 45 Whether improvements have substantially increased the value of a lot depends on the circumstances in each case. However, if the improvements increase the value of a lot by 10 percent or less, the increase will not be considered substantial; however, if the value of the lot is increased by more than 10 percent, then all relevant factors must be considered to determine whether the increase is substantial. 46 Improvements may increase the value of certain lots in a tract without affecting other lots in the same tract. Only the lots whose value was substantially increased are ineligible under Code Sec. 1237 . 47
If the tract has been held by the taxpayer for at least 10 years, an election is available whereby an improvement will be considered a necessary improvement not subject to the limitations of Code Sec. 1237(a)(2) . Under this election, an improvement will be considered a necessary improvement if all of the following conditions are met: 48
l The taxpayer has held the tract for 10 years. The full 10-year period must elapse even if the tract is inherited.
l The improvement consists of the building or installation of water, sewer or drainage facilities (either surface, sub-surface or both) or roads, including hard surface roads, curbs and gutters.
l The district director with whom the taxpayer must file his/her return is satisfied that, without such improvement, the lot sold would not have brought the prevailing local price for similar building sites.
l The taxpayer elects not to adjust the basis of the lot sold or any other property held by the taxpayer for any part of the cost of such improvement attributable to such lot and not to deduct any part of such cost as an expense.
A “similar building site” is any real property in the immediate vicinity whose size, terrain and other characteristics are comparable to the taxpayer’s property. For the purpose of determining whether a tract is marketable at the prevailing local price for similar building sites, the taxpayer must furnish the district director with sufficient evidence to compare (1) the value of the taxpayer’s property in an unimproved state with (2) the amount for which similar building sites, improved by the installation of water, sewer or drainage facilities or roads, have recently been sold, reduced by the present cost of such improvements. This comparison may be made and expressed in terms of dollars per square foot, dollars per acre or dollars per front foot, or in any other suitable terms depending upon the practice generally followed by real estate dealers in the taxpayer’s locality. The taxpayer must also furnish evidence, where possible, of the best bona fide offer received for the tract, or a lot within the tract, immediately before making the improvement to assist the district director in determining the value of the tract or lot if it had been sold in its unimproved state. 49
Example 1. A has been offered $5,000 per acre for a tract without roads, water or sewer facilities, which he has owned for 15 years. The adjacent tract has been subdivided and improved with water facilities and hard surface roads and has sold for $40,000 per acre. The estimated cost of roads and water facilities on the adjacent tract is $25,000 per acre. Therefore, the prevailing local price for similar building sites in the vicinity would be $15,000 per acre (i.e., $40,000 less $25,000). If A installed roads and water facilities at a cost of $25,000 per acre, his tract would sell for approximately $40,000 per acre. Under Code Sec. 1237(b)(3) , the installation of roads and water facilities would be considered a necessary improvement, if A elects to disregard the cost of such improvements ($25,000 per acre) in computing his cost or other basis for the lots sold from the tract, and in computing his basis for any other property owned by him. 50
Example 2. Assume the same facts as in the previous example, except that A can obtain $16,000 per acre for his tract without improvements. The installation of any substantial improvements would not constitute a necessary improvement under Code Sec. 1237(b)(3) , since the prevailing local price could have been obtained without any improvement. 51
Example 3. Assume the same facts as in Example 1, except that the adjacent tract has also been improved with sewer facilities, the present cost of which is $12,000 per acre. The installation of the substantial improvements would not constitute a necessary improvement under Code Sec. 1237(b)(3) on A’s part, since the prevailing local price ($40,000 less the sum of $12,000 plus $25,000, or $3,000) could have been obtained by A without any improvement. 52
Holding Period Requirement
To qualify under Code Sec. 1237 , the tract must have been held by the taxpayer for at least five years, unless it was inherited. 53 There is no holding period requirement for inherited property. However, according to the regulations, neither the survivor’s one-half of community property, nor property acquired by survivorship in a joint tenancy, is considered to be inherited property, and the holding period for the surviving spouse or joint tenant begins on the date the property was originally acquired. 54
Five-Lot Rule
Full capital gain treatment under Code Sec. 1237 is limited to the first five lots sold from a tract. In computing the number of lots or parcels sold, two or more contiguous lots sold to a single buyer in a single sale will be counted as only one parcel. 55
Example 4. A meets all the conditions of Code Sec. 1237 in subdividing and selling a single tract. In 2002 he sells four lots to B, C, D and E. In the same year F buys three adjacent lots. Since A has sold only five lots or parcels from the tract, any gain A realizes on the sales will be capital gain. 56
If more than five lots in the same tract are sold, gain from any sale, which occurs in or after the tax year in which the sixth lot is sold, is considered to be a gain from the sale of property held primarily for sale to customers in the ordinary course of a trade or business to the extent of five percent of the selling price. 57 However, any selling expenses incurred in the sale are first deducted from the amount that is treated as ordinary income. 58 Thus, if the taxpayer has sold the sixth lot or parcel from the same tract within the tax year, then the amount, if any, by which five percent of the selling price of each lot exceeds the expenses incurred in the sale, will, to the extent it represents gain, be taxed as ordinary income. Any part of the gain not treated as ordinary income will be treated as capital gain. If the selling expenses exceed the five percent of the gain that would otherwise be considered ordinary income, the excess of the expenses will reduce the gain that would otherwise be considered capital gain. The five-percent rule applies to all lots sold from the tract in the year the sixth lot or parcel is sold. Thus, if the taxpayer sells the first six lots of a single tract in one year, five percent of the selling price of each lot sold is treated as ordinary income and reduced by the selling expenses. On the other hand, if the taxpayer sells the first three lots of a single tract in 2001, and the next three lots in 2002, only the gain realized from the sales made in 2002 will be subject to the five-percent rule. 59
Example 5. Assume the selling price of the sixth lot of a tract is $10,000, the basis of the lot in the hands of the taxpayer is $5,000 and the expenses of sale are $750. The amount of gain realized by the taxpayer is $4,250, of which the amount of ordinary income attributable to the sale is zero, computed as shown in Table 1. 60
Table 1
Example 6. Assume the same facts as in Example 5, except that the expenses of sale of the sixth lot are $300. The amount of gain realized by the taxpayer is $4,700, of which the amount of ordinary income attributable to the sale is $200, computed as shown in Table 2. 61
Table 2
As used in Code Sec. 1237 , the term “tract” means either a single piece of real property or two or more pieces of real property, if they were contiguous at any time while held by the taxpayer or would have been contiguous but for the interposition of a road, street, railroad, stream or similar property. Properties are contiguous if their boundaries meet at one or more points. The single piece or the contiguous properties need not have been conveyed by a single deed. The taxpayer may have assembled them over a period of time and may hold them separately, jointly or as a partner, or in any combination of such forms of ownership. 62 If the taxpayer sells or exchanges no lots from the tract for a period of five years after the sale or exchange of at least one lot in the tract, then the remainder of the tract will be deemed a new tract for the purpose of counting the number of lots sold from the same tract. The pieces in the new tract need not be contiguous. The five-year period is measured between the dates of the sales or exchanges. 63
Relationship of Code Sec. 1237 to Code Sec. 1221
Avoiding dealer status is much more certain under Code Sec. 1237 as compared to Code Sec. 1221 . However, all the requirements and restrictions of the provision severely limit its practical application. Avoiding dealer status under Code Sec. 1221 , on the other hand, is highly uncertain but is not limited in its application. Fortunately, the two approaches are not mutually exclusive. If a transaction fails to qualify for capital gain treatment under Code Sec. 1237 , it may nonetheless qualify for capital gain treatment under Code Sec. 1221 , where the facts and circumstances establish that the property was not held primarily for sale to customers in the ordinary course of a trade or business. 64
Conclusion
For high-income taxpayers, ordinary income can be taxed as high as 38.6 percent in 2002 and 2003, 65 while capital gains are taxed at only 20 percent. 66 Where a large gain is realized on the sale of real estate, this rate differential can have a significant financial impact on the transaction. But, as demonstrated above, achieving capital gain treatment by avoiding dealer status requires careful and knowledgeable planning. Practitioners can assist taxpayers with real estate investments in the planning that may enable these taxpayers to avoid dealer status, resulting in substantial tax savings.
1 Code Sec. 1(h) .
2 Code Secs. 1221(a)(1) , 453(b)(2)(A) and 1031(a)(2)(A) .
3 Code Sec. 1221(a)(1) .
4 Code Sec. 61(a)(3) .
5 Code Sec. 1402(a) .
6 See, e.g., C.P. Snell, CA-5, 38-2 USTC ¶9417 , 97 F2d 891. Capital gains have been taxed preferentially since 1921; see Friedlander, ‘To
Customers’: The Forgotten Element in the Characterization of Gains on Sales of Real Property, 39 Tax L. Rev. 31 (Fall 1983).
7 Houston Endowment, Inc., CA-5, 79-2 USTC ¶9690 , 606 F2d 77.
8 V.H. Huey, CtCls, 74-2 USTC ¶9766 , 504 F2d 1388, 205 CtCls 557.
9 A.B. Winthrop, CA-5, 69-2 USTC ¶9686 , 417 F2d 905.
10 W. Malat, SCt, 66-1 USTC ¶9317 , 383 US 569, 86 SCt 1030.
11 See Biedenharn Realty Co., Inc., CA-5, 76-1 USTC ¶9194 , 526 F2d 409, cert. denied, SCt, 429 US 819, 97 SCt 64.
12 L.F. Paullus, 72 TCM 636, Dec. 51,554(M) , TC Memo. 1996-419.
13 See Winthrop, supra note 9.
14 See Biedenharn, supra note 11.
15 W.D. Little, 65 TCM 3025, Dec. 49,121(M) , TC Memo. 1993-281.
16 G.V. Buono, 74 TC 187, Dec. 36,925 (1980), acq., 1981-1 CB 1.
17 M. Hancock, 78 TCM 569, Dec. 53,577 , TC Memo. 1999-336.
18 G.A. Bush, 36 TCM 340, Dec. 34,311(M) , TC Memo. 1977-75, aff’d, CA-6, 80-1 USTC ¶9118 , 610 F2d 426.
19 Supra note 8.
20 Supra note 15.
21 J.D. Byram, CA-5, 83-1 USTC ¶9381 , 705 F2d 1418.
22 In re Jersey Land & Development Corp., CA-3, 76-2 USTC ¶9587 , 539 F2d 311.
23 Houston Endowment, Inc., supra note 7.
24 Byram, supra note 21, quoting from 35 Taxes 804, 806 (1957).
25 Supra note 6.
26 J.L. Van Drumen, 23 TCM 903, Dec. 26,821(M) , TC Memo. 1964-151.
27 See also R.L. Adam, 60 TC 996, Dec. 32,155 (1973). Accountant sold nine parcels of land in four years, ruled not in the business of selling real
estate.
28 N.A. Farry, 13 TC 8, Dec. 17,079 (1949).
29 See also R.D. Rouse, 39 TC 70, Dec. 25,701 (1962). Capital gain treatment was allowed on sale of 34 rental properties despite the fact that
taxpayer owned or controlled several corporations that built and sold homes.
30 Supra note 15.
31 Maddux Construction Co., 54 TC 1278, Dec. 30,174 (1970).
32 See also Ridgewood Land Co., Inc., 31 TCM 39, Dec. 31,219(M) , TC Memo. 1972-16, aff’d, CA-5, 73-1 USTC ¶9308 , 477 F2d 135. Land originally held for sale to customers was sold under condemnation order to state. Change of purpose resulted in capital gain treatment.
33 J.E. Heller Trust, CA-9, 67-2 USTC ¶9626 , 382 F2d 675.
34 See also C.R. Gangi, 54 TCM 1048, Dec. 44,319(M) , TC Memo. 1987-561. Capital gain treatment allowed (liquidation intent) where a 36-unit apartment building was converted to condominium units that were sold in slightly more than a one-year period.
35 Supra note 21.
36 R.H. Bramblett, CA-5, 92-1 USTC ¶50,252 , 960 F2d 526, rev’g, 59 TCM 876, Dec. 46,651(M) , TC Memo. 1990-296.
37 Reg. §1.1237-1(a)(1) .
38 S. Rep. No. 1622, 83d Cong., 2d Sess (1954).
39 Code Sec. 1237(a)(1) .
40 Id.
41 Reg. §1.1237-1(a)(2) .
42 Reg. §1.1237-1(a)(3) .
43 Code Sec. 1237(a)(2) .
44 Reg. §1.1237-1(c)(4) .
45 Reg. §1.1237-1(c)(3)(i) .
46 Reg. §1.1237-1(c)(3) (ii).
47 Reg. §1.1237-1(c)(3) (iii).
48 Code Sec. 1237(b)(3) and Reg. §1.1237-1(c)(5)(i) . For specific instructions on how to make the election, see Reg. §1.1237-1(c)(5) (iii).
49 Reg. §1.1237-1(c)(5) (ii).
50 Adapted from Reg. §1.1237-1(c)(5) , Example 1.
51 Id., Example 2.
52 Id., Example 3.
53 Code Sec. 1237(a)(3) .
54 Reg. §1.1237-1(d)(2) .
55 Reg. §1.1237-1(e)(2)(i) .
56 Adapted from Reg. §1.1237-1(e)(2)(i) , Example.
57 Code Sec. 1237(b)(1) .
58 Code Sec. 1237(b)(2) .
59 Reg. §1.1237-1(e)(2) (ii).
60 Adapted from Reg. §1.1237-1(e)(2) (ii), Example 1.
61 Id., Example 2.
62 Reg. §1.1237-1(g)(1) .
63 Reg. §1.1237-1(g)(2) .
64 Reg. §1.1237-1(a)(4)(i) .
65 Code Sec. 1 , as amended by the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16)
66 Code Sec. 1(h) .
Ho Boy! This was “lawyer speak” and rather strenuous reading, but Aunty would give him an A+ for his research.
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Article by John Hyre of RealEstateTaxLaw.com gives more info on the subject <here>.
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This is a response on a blogsite by SteveBuysHouses that sounds like a plan to me. I will run it by my accountant and attorney. Steve writes:
“Ok, here goes my .2 cents on this topic for what it is worth.
I meet with my CPA once per month for 2 hours going over our books and transactions, and most of our business last year was from wholesale deals (60 wholesales of our 88 transactions). That being said I will give you guys my take on this, because this is an issue I have been fighting for a couple of years now.
Problem 1: only deal with a CPA that is actionary not reactionary. Meaning you want a CPA that will strategize about what if this happens in our business based on our goals for next year? If X happens then we need to plan to do X. Not “wow you sold how many houses and made how much? crap your screwed. Let’s figure out how to save you as much as we can now”. The latter is reactionary. I don’t like that version.
Problem 2: The needs of your business will change and will start out at one level and end up at another. Because of this do not forget that you can adjust your strategy alltogether and switch from LLC taxed as an S-corp to LLC taxed as a C-corp and then disolve that to an actual S-corp or C-corp at a later date etc. The hard part is to figure out and understand which is best for you based on what level your company is at and you personally are at from an income standpoint etc.
Problem 3: Once an entity is considered a dealer you will not be able to come back from that classification to anther entity, however that may or may not be a bad thing. You need to plan on that happening and deal with that up front by segregating everything that will be in or go on in that entity. In other words if you are going to hold a property for longer than 12 months put it in a seperate entity, if you want to sell it tomorrow or in less than 12 months then put it in your dealer entity.
Problem 4: As long as you are selling in under 12 months and not doing a 1031 you will pay self employment or earned income taxes no matter what. Unless you like a room next to al capone in the clink (read out of fashioned orange jumpsuits and silver bracelets). Understand it and expect it and plan for it. The key to that is having the ability and foresight to plan ahead on your deductions and expense out to offset the income you make.”
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Michael Hauser, CPA/JD (means he is an accountant AND an attorney!) on dealer status:
As many of you are aware, a federal tax rate discount of up to 20 percent is available for sales of “capital” assets (property held for long-term market appreciation), as opposed to sales of “dealer” property (property bought and sold as a business). The tax break is available to individuals, partnerships and “S” corporations that sell capital assets they have owned for over one year. You may not be aware that sales of capital assets qualify for two additional benefits — first, gain from seller-financed sales of capital assets can be deferred under the installment sale rules of § 453 and, second, the gain from sales of capital assets can be deferred through a § 1031 exchange. But none of these tax benefits are available for “dealer” property.
This begs the question: Is real estate considered a “dealer” asset? It is widely presumed that developers and frequent real estate sellers are tainted as “dealers” and will never have capital gain from the sale of real estate. However, the actual rule is that capital gains cannot result from “property held primarily for sale to customers in the ordinary course of a trade or business.” Thus, even a taxpayer actively engaged in real estate can claim capital gains from the sale of real estate which (1) is held primarily for investment, rental or intended future rental, (2) is not sold as part of an established trade or business, or (3) is not sold within the ordinary course of the taxpayer’s business. Thus, a facts-and-circumstances test will determine whether a real estate asset is dealer property.
Avoiding Dealer Status
Planning can make the difference in avoiding dealer status by helping to create positive facts related to the facts-and-circumstances test. For example, when feasible, each parcel should be held in a separate entity. Related entities are generally considered distinct “taxpayers” even if they have the same owner or owners (“entity-level characterization”). Even if a taxpayer would be a “dealer” if he or she bought and sold properties through a single entity, “dealer” status could possibly be avoided if each property is owned through a separate entity. Note: For an LLC to be a recognized entity for tax purposes, it must have more than one member or it must elect to be taxed as a corporation. In the partnership context, the Supreme Court has held that, for purposes of “ascertain[ing] and report[ing]” a partnership’s income, “the partnership is regarded as an independently recognizable entity apart from the aggregate of its partners” (Basye, 410 U.S. 441 (1973)).
Thus, in a case involving the sale of residential real estate, the Tax Court stated that “the partnership is to be viewed as an entity and [gain and loss] items are to be characterized from the viewpoint of the partnership rather than from the viewpoint of the individual partner” (Podell, 55 TC 429 (1970)). Similar rules apply in the case of an S corporation. It is still somewhat helpful if the related entities have at least some differences in their ownership composition, but even identical ownership has been approved of in the case law, most notably in Phelan, TC Memo 2004–206 and Bramblett, 960 F.2d 526 (5th Cir. 1992.)
For taxpayers who are “dealers,” each parcel is considered separately to determine if it is dealer property. Taxpayers and their professional advisers should collect evidence that parcels are held for investment, as opposed to being held for sale in the ordinary course of a trade or business. In transaction documents, it is helpful to have self-serving language evidence “investment” intent, and to avoid the terms dealer, development and sales. These terms (good or bad) may appear in the recitals to the purchase agreement, in the entity’s legal name, on the tax return and in the entity’s statement of purpose in its Articles of Organization or Operating Agreement.
How can a residential builder who primarily sells single-family homes in the ordinary course of a business avoid dealer status? They may be able to divide profits between capital gains (on land appreciation) and ordinary income (on building profits). Assume an LLC buys land, begins development two years later, and then subdivides and sells individual residential units. Since the LLC is engaged in development, the profits would be ordinary income. Assume instead the LLC passively held title to the land for investment (as evidenced by the documents mentioned above), while a separate S corporation (with the same owners) obtains government approvals and orders surveys, blueprints and architectural work (as evidenced by having correspondence and payments for these items come from the S corporation). Just before development, when the project has appreciated due to market factors and rezoning, the property gets sold from the LLC to the S corporation. The raw land sale could produce capital gain on the pre-development appreciation (and most of the capital gain itself could get deferred through an installment sale/“wrap mortgage” arrangement).
Whether or not this method is viable depends on some critical factors. First, a business purpose for the related-party sale, apart from tax motivations, is essential. Often a business purpose can be justified on a “limitation of liabilities” or “segregation of liabilities” theory. In Bramblett, a sale from a general partnership to an S corporation, both of which had the exact same owners, was considered a legitimate transaction for tax purposes because the owners had a business purpose of moving the property to a corporation before beginning development work so that they would receive limited liability under state law. In Phelan, an LLC sold real estate to an identically owned S corporation — however, there was a business purpose since less than the entire parcel was going to be developed, and thus the owners wanted the undeveloped land to remain in the LLC so that liabilities related to the new development activity would be segregated away from the remaining land. A second essential factor is that the sale cannot be between two commonly owned partnerships — one entity must be a corporation (S or C). Third, the sale must be at fair market value (taxpayers cannot inflate the capital gain portion).
Conclusion
An even simpler scenario is the following: What if an investor has held a parcel for 20 years and then teams up with a developer in an LLC to develop it? All of the investor’s income will be tainted by the developer, and turned into ordinary income. This harsh result can be avoided by having the investor sell the raw land prior to development to a new entity owned by both he and the developer — this will allow him to bifurcate his profit into a taxable sale of a capital asset, followed by ordinary business income from the development and sale, which will occur later.
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A rather delightful article about dealer status, basically it comes down to who can say? This one by Michael Plaks.
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Doing a Google search – I found another excellent article written by an attorney on Maui(!) – Richard Frunzi, JD. It sounds like he also does entity formation and maintenance for his clients, quite similar to Boss Business Services.
Here’s a link to a website page about dealer status written by an attorney very savvy about real estate law and accounting. Thank you Mr Frunzi for giving me permission to reproduce on this site.
I am reprinting in entirety here:
In today’s real estate market — the hot one we are just leaving or the next one we are about to enter — many taxpayers are recognizing significant gains when disposing of their real estate holdings. Based on the large disparity between gains that are taxed at the long-term capital gains rate and the ordinary income tax rates currently in place, most taxpayers seek to structure their transactions such that they will be able to avail themselves of the more favorable capital gains treatment afforded those who sell investment real estate.
In its simplest sense, investors hold real property for its investment value while dealers hold real estate as any business would hold its own inventory: “for sale” if and when a buyer appears. Whether a taxpayer is a real estate dealer is a question of fact. A party may be found to be engaged in the business of buying and selling real estate, for instance, by reason of organization and method of activities. A dealer is therefore probably best defined as a party who is involved in the sale of goods and has no present intention to hold those goods other than for immediate sale. That is, in the hands of a dealer, real property parcels are primarily inventory items, or goods primarily for resale rather than items that are being held for trade or business or for investment. For the most part, real estate dealers buy, improve and sell real property as part of their everyday business. While such business need not be the only business in which such party is involved, it is often the most significant or one of the most significant ventures in which such party is involved. In other words, even though a taxpayer may take part in other activities such as farming or a profession, in order to usually be deemed a dealer in real property, the real estate activities need to amount to a “business” in the sense of an occupation to which such party devotes time, attention, or effort, either personally or through others, with substantial regularity.
In contrast, as a general rule, those who are real estate investors purchase real property with the intention of holding their properties and gaining a financial return from its ownership. A person acquiring property strictly for investment, though disposing of investment assets at intermittent intervals, is not regularly engaged in dealing in real estate unless he or she clearly changes his original intention before proceeding to sell such property.
Ordinary Income Taxation Upon Sale of Inventory Held By A Dealer. Despite one’s desires, the appropriate income tax treatment depends solely upon the taxpayer’s status as either an investor or dealer in real estate. The tax laws are clear on one thing: if as a dealer one sells real property, the taxpayer-seller will be taxed as if the sale were of any other kind of inventory: as ordinary income. In summary, whether a dealer is selling automobiles, antiques or real property, once an asset is determined to be held for sale as an inventory item, any gain upon its sale or other disposition results in ordinary income to the selling party. In recognition that investors in real property hold their investments for a longer term gain as opposed to the shorter-term perspective that a dealer would ordinarily have, the tax law encourages such investment through the preferential income tax treatment afforded gains on the value of such investments; also known as capital gains.
Ability (Really, Inability) Of Dealers To Qualify For Installment Sale Treatment. Section 453(b)(2) of the Internal Revenue Code provides that the installment sales method of reporting income or other gain received after the year of the sale from the sale of an asset is not available for “dealer dispositions.” The Code provides that a “dealer disposition” specifically includes “any disposition of real property which is held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business. [Code Section 453(I)(1)(B)]. Although there are exceptions to this rule, most exceptions are not useful to dealers selling real property. In the case where a dealer can not qualify for using the installment sales method to spread the gain over the number of years over which the payments are received, the taxpayer is required to pick up the entire gain in the year in which the sale occurs.
Ability (Again, Really, Inability) To Utilize Benefits of Tax Deferred Exchanges Pursuant to Code Section 1031. As you are all aware, taxpayers who hold real property for investment purposes can qualify under the terms and conditions of Code Section 1031 to replace real property being sold with other real property the replacement of which can defer the recognition by the taxpayer of the gain on the initial sale. Unfortunately, pursuant to the rules of Section 1031(a)(2)(a), those who hold real property as inventory are not able to qualify the disposition of such real property for tax free deferral as part of a 1031 exchange because pursuant to the Treasury Regulations, such property is not considered “property held for productive use in a trade or business or for investment.”
And On Top Of All That: Self-Employment Taxes! One of the items least thought about with the issue of whether one is a dealer is the position by the IRS that has been constantly sustained in the courts that when a dealer in real property sells property, not only is the gain realized taxable as ordinary income, in almost every circumstance, the amount of the gain is more than likely going to be subject to self-employment taxation. That’s potentially as much as an additional 15.3% on the first $97,000.00 of a taxpayer’s income from such activities. Well, at least the self-employment taxes go down to 2.9% for all self-employment taxable income in excess of $97,000.00 for 2007!!
While it would seem a rather simple determination to make as to whether a taxpayer held an asset, whether real property or some other asset, as inventory or for investment purposes, the issue remains complicated since neither the Internal Revenue Code nor the regulations issued by the United States Treasury provide an authoritative list of criteria to differentiate the real estate dealer from an investor. For this reason, most of the determinations upon which a taxpayer can rely come from court decisions interpreting the rules relating to dealer status. The decisions which have been reported on determining dealer status for a taxpayer have one characteristic in common: they are fabulously inconsistent in providing any conformity and/or guidance by which a reasonable person could make the determination as to whether under all but the most clear of fact patterns, a taxpayer is or isn’t a dealer. Stated otherwise, these court decisions make it clear that a specific factor or combination of factors does not always control the results in these decisions. In United States v. Winthrop, the judge held that the factors identified in the law do not separate “sellers garlanded with capital gains from those beflowered in the garden of ordinary income.” [417 F.2d 905 (5th Cir. 1969.)]
Main Factors In Determining Whether The Dealer Status Shoe Fits (Even If You Don’t Want It To)
What are the main issues that are reviewed in determining whether a taxpayer is a dealer in real property? As noted above, in reviewing claims by the IRS as to whether a taxpayer should be considered to be a dealer in real property, the courts have in practice tended to review the following factors in arriving at their decisions:
==> The extent and nature of the taxpayer’s efforts to sell the property.
==> The number, extent, continuity and substantiality of the sales.
==> The extent of subdividing, developing and improving the property to increase sales.
==> The use of a business office for the sale of the property.
==> The character and degree of supervision or control exercised by the taxpayer over the representative selling the property.
==> The time and effort the taxpayer habitually devoted to the sale of the property.
==> The duration of ownership (proximity of the sale to the purchase).
==> The extent of advertising and solicitation by the taxpayer or others on his/her behalf.
While courts addressing the issue of whether a taxpayer is a dealer have consistently mentioned the nine factors listed above, only a few of these have been critical to decisions in most cases.
Pivotal Issue One: Intent of Seller. The pivotal issue, consistently, has been the purpose for which the taxpayer held the property immediately prior to sale. This means that property purchased originally as an investment may be considered, by the IRS and courts, as having been converted to inventory. Alternatively, property purchased originally for sale to customers in the ordinary course of business may have been converted to investment property.
Pivotal Issue Two: Subdivision, Development or Improvement Efforts Taken By Seller. The issue next most affecting court decisions has been the extent to which the property was subdivided, developed and improved in order to increase sales. If a taxpayer subdivides real property or makes substantial improvements to the property so that its value is greatly enhanced, then the taxpayer will most likely be deemed a dealer in real property.
Pivotal Issue Three: Sales Efforts of Seller. The third most commented on factor in the determination of whether a taxpayer is or isn’t a dealer appears to be the number, extent, continuity and substantiality of sales. The greater the number of real estate sales the taxpayer makes, the more likely the taxpayer will be designated a dealer in real property.
Benefits of Being Classified As A Dealer In Real Property: Is It Always Bad To Be Considered A Dealer In Real Property? However limited in relation to the costs of being classified as a dealer in real property, there are some benefits to being so classified:
(a) Offsetting Losses Generated By A Sale of Real Property. Interestingly, if a taxpayer could purposely structure his or her transactions such that the classification as a dealer in real property would not permanently affect such taxpayer, in a declining real estate market, the classification of a project as a sale of inventory would permit a taxpayer with an overall loss to make such loss fully deductible in full as an ordinary loss in the year of sale rather than being subject to the $3,000 per year limitation on offsetting capital losses against other income.
(b) Expenses For Real Estate Activities. As a general rule, a dealer in real property who is actively and continuously engaged in buying and selling real estate may pursuant to the rules of Code Section 162(a) deduct from gross income all ordinary and necessary expenditures directly connected with or pertaining to its sale, rental and management of real estate.
Planning To Avoid Dealer Status: Trying Not To Get That Dealer Stench All Over Yourself.
One of the disadvantages of being classified as a dealer is that the principle followed by the IRS is the once a dealer, always a dealer rule. To be more precise, as noted above, just because a taxpayer is considered to be a dealer in one or more transactions, that does not mean that such taxpayer is a dealer in every transaction in which they are engaged. But, that said, it does mean that the presumption about whether they are a dealer has changed. Prior to when a taxpayer is considered to be a dealer in real property, the presumption upon any sale is made as an investor. Once, however, a taxpayer has been determined to be a dealer in real property, from the point in time that uch dealer determination occurs, the presumption has now shifted and the burden from that time forward is that the taxpayer, presumed to be a dealer with respect to all real property, must by a preponderance of the evidence, demonstrate that the taxpayer is not a dealer but rather an investor with respect to one or more specific properties.
If it is fair to assume that a taxpayer has been engaged as a dealer in real property in one or more prior ventures, what can be done to insulate such taxpayer from having the “stink” of being a dealer infect each and every future real estate transaction? While it would be wise to at first avoid all classification as a dealer in every situation, sometimes the facts are just plain against you. In those instances, in order to protect a taxpayer against the dealer status that might result from such a project and thereby either contaminate the taxpayer’s qualification as a non-dealer for those future investments in real property that may be made by the taxpayer or even for past transactions that the IRS might scrutinize, there are some actions (or inactions) which can be pursued in order to minimize the effect of being classified as a dealer in real property:
1. Five Year Rule For Dealers Who Want To Sell Real Property. The Internal Revenue Code specifically permits one who is otherwise classified as a dealer be treated as an investor with respect to real property which meets the rules of Code Section 1237(a). Pursuant to this rule, any taxpayer who holds real property for at least five years and (a) has not previously held any part of the same land primarily for sale to customers in the ordinary course of business, (b) has not held any other real estate for sale to customers during the year of the sale and (c) does not made substantial improvements to the property which substantially increase the value of the lot sold can safely dispose of such real property, even if the taxpayer has subdivided the land for purposes of sale or engaged in activities incident to such subdivision, either through a sale or as part of an exchange under Code Section 1031.
2. Use The Develop And Hold Some Lots Back Technique. A common technique often employed by those who develop real property is to sell only a portion of the parcels developed with a plan to retain the remaining parcels for investment purposes. The IRS has granted taxpayers non-dealer status on the later sale of these transferred lots when such a transactional structure is used. Of course, the facts of each situation will dictate the number of lots that should be retained and the advisable retention period prior to the sale of such remaining lot in order to qualify such later sales as non-dealer status sales.
3. Use the Early Sale To A Related But Different Entity In Order To Classify Such Early Profits As Investor Profits. In some cases it may make sense to structure a development project such that after some non-substantial portion of the project has been completed, but after the long-term holding period has been met and the actual development is ready to be started, the taxpayer or taxpayers developing the project sell off their interest in the project to a related but not too related entity in order to qualify at least that portion of the gain as non-dealer gains subject to the lower capital gains tax treatment afforded sales by investors.
It is important to note that where a partnership is used (or, for that matter, a limited liability company treated as a partnership for income tax purposes), the structuring of the purchasing entity as a corporation may be critical to the success of such plan in order to avoid the situation where the IRS takes the position that the purchase by a partnership from a partnership of related individuals is merely a continuation for income taxes of such original seller-partnership and therefore not a sale for income tax purposes which affords the seller-partnership or its partners capital gains treatment upon such sale.
4. Plan The Ownership Structure of Each Development Entity Such That The Classification of A Single Venture Does Not Contaminate All Other Ventures. One of the most successful methods of minimizing the effect of either having a current project determined to be inventory or of having one or more previous projects determined to be inventory and thereby affecting the income taxation of both future and more recent past projects determined to be inventory held by the taxpayer as dealer property is to properly structure the ownership of each project in the first instance.
There is little question under the current tax law that the development of real property in a taxpayer’s sole name, as a co-tenant with other co-tenants, or as a member of a limited liability company or as a partner of a general partnership have the same result with respect to the responsible individual being considered a dealer for income tax purposes. For the entities, the IRS takes the position that development by an entity can result in the “passing through” of any dealer status to the individuals ultimately responsible for such development. In other words, the use of a limited liability company or a general partnership does not minimize the probability that the when the entity is determined to be a dealer that the owners of such entity will bear the ultimate branding of being a dealer in real property.
Possibly more importantly, the determination that a taxpayer has been determined to be a dealer for real property can have the effect of exposing individuals in later partnerships or developments of such dealer-taxpayer to greater scrutiny as to whether they, too, are dealers rather than investors. In other words, being determined to be a dealer can be contagious on your future partners.
Using A Family Limited Partnerships Can Be A Useful Method To Avoid The Pass Through of The Dealer Stink To Each of Its Partners. Family limited partnerships are one of the more recent, successful and attractive methods by which taxpayers who have been determined to be dealers or who haven’t yet been so designated but still wish to avoid the likelihood that (a) they will be personally considered a dealer for income tax purposes or (b) if they are entering into a project for which they will be a dealer, but hope to limit their designation as a dealer to a specific single project. Family partnerships offer a method to effect a transfer of assets to family members with both estate and income tax benefits while in practice permitting the donor-transferor to retain some control over the asset to be transferred. While there are certainly other methods to transfer assets to family members other than through the partnership vehicle, for the real estate investor, especially one who fears being labeled a dealer in real property, there may be no structure better than using a family limited partnership to accomplish the estate planning, income tax planning and dealer avoidance goals which can be obtained through the use of such an ownership vehicle. In order for any entity, including a family limited partnership to be useful in avoiding the passing through of dealer status to its individual partners it is usually best if there is a clear business and/or estate planning purpose for the use of such an entity other than merely to avoid having the partners individually labeled as dealers if the entity receives such classification.
In general, family partnerships offer a number of advantages over the alternative methods of ownership without the disadvantages faced with other structural choices, including:
a. the power to retain control over the venture’s investments;
b. the power to retain control over actual distributions by the venture to owners; and
c. single-level taxation without the complexity imparted on S corporations under the Internal Revenue Service rules.
Like it or not, unfortunately the liability picture we all face these days is grim. Insurance costs are once again on the rise, being led by the rising costs of not only liability that is assessed, but also by the costs of defending against such liability where liability is not proven. Asset-rich individuals are inviting targets for plaintiff’s lawyers seeking a payday. In addition to being pushed up the liability exposure tree by having assets, many individuals are helped up that tree because of the nature of how they earn their living in a high liability field.
There are no guarantees against liability exposure. There are lots of offers for complete liability protection, but you might as well spend your money in Vegas at the craps table as to invest in one of these hopeless plans for protection against catastrophic loss. Anyone who tells you different is being disingenuous. That’s a fancy word for “lying.” That said, there are some ways to minimize the chance that what you have will be taken. This is not a panacea. It does not void or mean that any judgment against you will be defeated. But it does mean that you can make it somewhat more difficult for any potential creditor to have less of a chance to get to the assets themselves. How does this work? It all relates to partnership law. Partnership law allows a partnership to provide that no one can become a substitute partner merely because they acquire the units held by one of the partners. In English, please? If a parent gets sued and that person has, say, a rental house in their name, that house is up for grabs if a creditor gets a judgment against them. If, on the other hand, a valid partnership were formed and this same rental house were transferred to the partnership before the liability had been created, even if the parent in this instance were to be sued and a judgment against them obtained, this does not mean that the house itself would necessarily be at risk of being taken by such creditor. All that this creditor is allowed by state law to get is a “charging order” against the partnership which would prohibit distributions to the partner – the distributions to the partner would, in effect, have to be paid out to the creditor with the charging order. They do not gain any interest in the assets themselves that are held in the partnership. These are protected for the benefit of the remaining partners. The assets can still, despite the charging order, be held and maintained by the partnership. The partnership can still pay out salaries and other compensation to family members other than the party against whom the charging order has been issued. It is not by any means a perfect solution, but there are no magic wands here. It is one way in which to possibly force a creditor to accept less than one hundred cents on the dollar for such liability and be able to retain the underlying assets which have been held by the family and which the family wishes to retain.
Limited partnerships also provide a way to protect those to whom the gifts are made. Possible divorces, silly or irresponsible children, children or grandchildren who are too young to receive direct ownership in the partnership or even children or grandchildren who face liability from their work or otherwise all on their own can be handled through the use of a family partnership. If liability is a concern for the current owners, since these individuals are not presently owners on the property as far as what might be gifted to them, gifts can be made into an irrevocable trust rather than to such persons individually. How does such trust work? Since this trust would be irrevocable (as opposed to those revocable trusts which are used for estate planning purposes basically in place of a will), the assets held by it would not be considered to be owned by the beneficiaries of the trust. There are special laws relating to assets held in irrevocable trusts referred to as “spendthrift” provisions that protect persons who may have liability claims against them. These protections can be strengthened by permitting the trustee of the irrevocable trust (basically the same as the manager of a business) to have the power to withhold distributions of principal except for certain beneficiary needs. Spendthrift protections offer resistance from claims in divorce as well as claims for professional and business liability.
In some instances, one or more family members are in careers and/or professions that expose them not only to liability but also to the claim that the might be dealers in real property for tax purposes. One of the benefits of utilizing a family limited partnership in an estate plan is that if the partnership itself is properly structured with both limited and general partners then the IRS may have a much more difficult time in forcing the dealer status through the entity to the individual partners of the partnership individually. More particularly, if the family limited partnership is ever determined to be a dealer in real property, the partnership itself can be dissolved and a new partnership or other entity thereafter created for future projects, thereby presenting developers to continue on without the likelihood of compromising all future ventures into which such taxpayer may belong.
Rules To Live By In An “I Don’t Want To Be Called A Dealer” World.
1. The more projects a taxpayer has going (either at a single time or relatively close together, the harder it is going to be to make certain that any one project will not be considered a dealer project consisting of inventory for sale. The entity structure decisions you make are most important in planning to protect against contamination of this project on others or on others on this project.
2. A taxpayer’s intent both at the time of the acquisition of real property as well as at the time of sale is both objectively and subjectively very important in determining whether a taxpayer lives by the sword or dies as an aptly named dealer in real property. Try to make your records show that you acquired property for investment purposes if it is true and show that the reason why you are selling is not because you are holding it as inventory.
3. Time your sales as best as you can to not make it look like you always have one or more parcels of real property for sale. How many cars have you sold in the last ten years? You should not be selling more parcels of land than you have sold number of cars. Trust me on this. Even if the actual number of sales is negligible, ordinary income tax treatment as a dealer can occur if a taxpayer has engaged in frequent and continuous sales efforts. Likewise, be aware that the frequency of sales is perhaps the most important factor evaluated by the courts on this issue. The best offer is an unsolicited offer.
4. Don’t do stupid things. For instance, while not conclusive, if a taxpayer names the entity that develops or improves real property as Aloha Development Company, he or she might as well have named it Aloha Please Audit Me And Call Me A Dealer Company. The name can not possibly help. Will it hurt? Don’t know, but I am sure you can find a slightly less antagonizing name. Your accountant will love you for choosing a less controversial name. Some tax preparers have been known to actually flinch when presented with a company name that includes the term “Developer” or “Development” in it.
5. Finally, a word of caution to taxpayers who are actually full time realtors. The courts have frequently said that a dealer in real property can also hold property as an investor. One exception which the IRS and courts recognize is that any real property held for more than five years by a taxpayer who is otherwise a dealer in real property will be considered held for investment purposes and capable of qualifying for capital gains treatment upon sale. The courts have, however, held that dealers are subject to a greater burden of proof than a non-dealer. Segregation of the property on such taxpayer’s books and records is important for the dealer in obtaining capital gains treatment on the sale of real property held for investment purposes.
Only a few things in life are certain: death and taxes. It is usually better to make sure that they are not dealer taxes ….
In closing, we wish to confirm that this memorandum has been provided to you for informational purposes only. All of the information and statements made in this memo are general in nature. Accordingly, we can assume no responsibility for the success or failure of any exchange if such exchange is conducted without our continued assistance. If you have any further questions, please feel free to give our office a call.
We hope this has been helpful. We here at webMinutes.com are more than happy to provide information such as this to you in the hopes that it will make you more informed about the rules relating to this subject.
© 2010 Richard L. Frunzi and Business Documents, LLC
Wow! Mahalo Richard Frunzi! That was a great article full of great information!
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Did you make it to the end, Dear Reader? Congratulations if you did – this was heavy stuff, and a lot of it. Having a great attorney who know this stuff (I have Michael Bowman of BOSS) and a great CPA who understands real estate investing (I have Diane Sandlin) helps me sleep very well since they already know most of this stuff. I hope none of you gets tagged as a dealer, unless it is in Vegas, on the tables.
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