Understanding Your Classification as a Real Estate Investor or a Dealer is Crucial in a 1031 Exchange by John G. Ebenger, CPA
Posted on July 19, 2024
by
John Ebenger
There are many different types of participants in the real estate market and an equally diverse set of rules for how each may treat profits and losses from property sales. For example, real estate investors may claim the tax deferral benefits of a 1031 exchange, but these benefits and rules generally do not apply to real estate dealers. Making this distinction is not clear-cut. Instead, the IRS looks at the property owner’s unique facts and circumstances and their intent concerning both the relinquished property and the replacement property.
A 1031 exchange, named after a section of the U.S. Internal Revenue Code, provides a significant tax advantage to real estate investors who purchase property for productive use in a trade or business or for investment purposes and hold it with the intent to yield a financial gain. Generally, investors’ property sales are subject to long-term gains tax, which max out at a rate of 23.8 percent when including the 3.8 percent net investment income tax. However, the law allows investors to defer taxes on capital gains from the sale of investment property when they reinvest the sales proceeds into a similar, like-kind property. This lack of an immediate tax burden further enables investors to gain better control of their cash flow, grow and diversify their portfolio of properties for many years and potentially leave their heirs with a tax-free gift when they pass away.
By contrast, real estate dealers are individuals whose primary business activities involve buying and selling properties to customers. They treat their properties as inventory and, therefore, record sales as ordinary income or losses with income taxed as high as 39.6 percent. To distinguish dealers from investors, the IRS looks at taxpayers’ individual properties and related transactions rather than taking a broad view of all their activities in a given year. For example, consideration is given to the purpose of the taxpayers’ property acquisition, the holding period, the frequency of their transactions and the nature of their business activities. More specifically, taxpayers seeking capital gains treatment of property sales and the tax deferral benefits of a 1031 exchange must meet the following criteria to qualify as real estate investors.
Nature and Purpose of Acquisitions and Sales
Properties acquired for long-term investment or rental purposes are more likely to be investor activities. This contrasts with dealers who purchase property with the intent to resell quickly for a profit.
Duration of Ownership
Investors typically hold properties over a long period to yield rental income and long-term appreciation. Conversely, properties held briefly (less than a year) before a sale often suggest dealer status.
Nature and Extent of Property Development and Improvement
Investors may make minor improvements to their properties as a part of their long-term investment strategy. However, dealers typically expend significant resources to develop, subdivide and improve their properties before a sale.
Nature and Extent of Efforts to Sell Properties
Dealers are more likely than investors to commit significant time, effort, and advertising dollars to attract buyers and sell their properties. They also tend to have business offices committed explicitly to selling a property.
Number, Frequency and Continuity of Property Sales
Investors commonly engage in a small number of transactions over a long period, whereas dealers tend to have a high volume of transactions over a shorter period.
Despite these strict rules, there are times when a real estate dealer may be considered an investor, or vice versa. Moreover, it is possible that a taxpayer acts as both a dealer and investor on the same parcel of property (made up of various components). Under all these circumstances, it is critical taxpayers collaborate with their trusted advisors to plan carefully before engaging in a 1031 exchange and properly document their activities and intentions to realize preferable tax treatment and the benefits that a 1031 exchange entails.
About the Author: John G. Ebenger, CPA, is a director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he works with real estate developers, landholders, investment funds and high-net-worth entrepreneurs with complex holdings. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or info@bpbcpa.com.
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