Investor vs. Dealer Status

In todays hot real estate market, many taxpayers are recognizing significant gains when disposing of their real estate holdings. With the large disparity in long-term capital gain and ordinary income tax rates, most taxpayers are seeking capital gain treatment. However, the appropriate treatment depends on the taxpayers status as either an investor or dealer of real estate. Dealer, in the context of this discussion, is a term commonly used to describe a person who holds real property for sale, rather than for investment.

Real property will not be deemed a capital asset if it is held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, under Sec. 1221(a)(1) (hereinafter de-scribed as being for sale); thus, gains or losses on real property held for sale will be ordinary in character. If the property is not deemed for sale, the gains or losses will be capital (or, in the case of depreciable rental property, a Sec. 1231 gain or loss). To qualify for the preferential long-term capital-gain rates, the property must be held for over one year.

Held for Sale or Investment?

There is no bright-line test to determine whether property is held for sale or investment. Some factors the IRS considers when determining the propertys status are:

• Purpose of the acquisition and period held;

• Taxpayers efforts to sell the property;

• Extent, continuity and substantiality of sales;

• Extent of subdividing, developing and advertising to increase sales;

• Character and degree of control exercised by the taxpayer over any representative selling the property; and

• Time and effort the taxpayer de-voted to the sales.

The more frequent the sales, the more time and effort spent on sales;  the shorter the period the property is held, the stronger the case for dealer status (see Phelan, TC Memo 2004-206, discussed in Sartain, Tax Clinic, Capital Gain on Development Property, TTA, December 2004).

As mentioned above, an obvious disadvantage to dealer status is that it subjects gains to ordinary tax rates. Other disadvantages are the inability to use the installment sale method and Sec. 1031 tax-free like-kind exchanges. By contrast, dealers can offset losses against ordinary income with fewer restrictions than capital losses. Also, property held
for sale is not subject to Sec. 163(d)s investment interest limits; under Sec. 163(d)(5), only property held for investment is subject to Sec. 163(d).

Strategy

Taxpayers seeking to strengthen a position as an investor can take certain practical and simple steps:

1. Consider using the word investments in the name and organizational documents when creating an entity to hold the investment properties.

2. Code the principal business activity on the tax return as real estate investment, not as development.

3. Reflect the property holdings on financial statements as investments.

4. Extend the holding period for as long as possible, and minimize the frequency of sales as much as possible, within reason.

Dealer status will not automatically disqualify a taxpayer from holding certain property for investment; however, it would seem that dealers may have to sustain a heavier burden to prove that fact. As such, they should hold their investment properties in entities separate from property that could be potentially subject to ordinary income treatment.

Using a partnership and an S corporation: Commonly, to obtain dealer status, many developers form a partnership to buy and hold land for over a year. During that time, there is minimal, if any, development activity. After the long-term holding period is met and development is ready to begin, the partnership sells the property to a second entity set up as a commonly owned S corporation. The S corporation then starts to develop the property. In this scenario, the taxpayer claims capital gain treatment on the initial sale to the S corporation, and ordinary income treatment on the ultimate sale of the developed property; see Bramblett, 960 F2d 526 (5th Cir. 1992).

An essential component of this strategy is to have the initial sale be between a partnership and a corporation, because, under Sec. 707(b)(2)(B), a gain on the sale of property between two commonly owned partnerships will always result in ordinary income if the property is ordinary income in the purchasing partnerships hands. Currently, no such limit exists on sales between commonly owned partnerships and corporations. When using this strategy, all sales should be at fair market value.

Conclusion

There are many opportunities to consult with clients about dealer or investor status. With the proper tax planning and the right circumstances, funds can remain in the taxpayers pocket for future real estate ventures.

From Benjamin Matherly, and Russ Matthys, CPA, South Bend, IN