The Problems With Real Estate Dealer Status

There are a couple of problems with the real estate dealer status. Your best way to handle them is to get in front of it with a strategy. The two problems discussed in this blog today are:

  • There is no capital gains treatment of income. All income is taxed as ordinary income.
  • You cannot take the installment tax treatment, resulting in all income being immediately taxable on sales.

Problem: There is no capital gains treatment of income, meaning all income is taxed as ordinary income.

Solution: If a property will be held over one year, look for ways to flunk the dealer status for that property. Long-term capitals special rates don’t kick in until a property or asset has been held for over one year. So, a dealer status property that is sold after being held for less than a year will have an income tax rate that is the same as the short-term capital gain. Dealer status only matters here if the property is held for over a year.

If you can prove that a property was purchased to be held for a longer period of time, then you will flunk dealer status. Many investors who have both properties with and without dealer status use business structures to make a clear delineation between the two.

Problem: You cannot take the installment tax treatment, resulting in all income being immediately taxable on sales.

If you sell a property and carry back a note (either through straight owner financing, as a second mortgage or wrapping a mortgage) you have to wait to get paid. One of the tax benefits that you might get (if you’re not a real estate dealer on this property) is that you also can wait to pay the taxes.

So, for example, let’s say that you buy a property for $80,000 and make $20,000 in improvements. You have a total of $100,000 in basis. Then let’s say you now sell it for $150,000. You have gain of $50,000. You get a down payment of $5,000 and then will receive principal and interest payments.

If you have installment gain tax treatment, you’ll pay tax on 1/3 of the down payment. The other 2/3 is considered a return of principal. That means $3,333 is taxable, $6,667 is not taxable.

The payments will be principal and interest. The interest is taxable. The principal would be 2/3 is return of principal and 1/3 taxable as gain.

But if you’re a real estate dealer, that won’t work for you. In that case, you’ll have to pay tax on the full amount of the gain – $50,000. It doesn’t matter how much cash you get, or when you get it. A real estate dealer can not take advantage of the installment sales tax treatment for tax.

A better solution may be to take options to sell with a rent to own program instead of doing owner financing. In that case, a deposit (usually non refundable) is received and a part of rent payments apply to a future purchase of the property. When the option is triggered, the sale occurs. There is no tax due on the future gain during the lease period because the tenant buyer has not yet exercised the option.

Got a question about today’s post or have another real estate tax question? Please go to our link on the home page to submit your question. I’ll do a blog post answering your question.