If you’re a real estate dealer, under the IRS definition, you have a business, not passive investments. There are pros and cons to that definition. A big “pro” is that you get to take a full deduction for losses you have sufficient basis and, provided to have active participation (lower standard than what you need for real estate passive losses). For the “cons”, there are two main ones:
- You will pay self-employment tax of 15.3% on top of regular income tax unless you’re in the right business structure, and
- You will have to pay accelerated tax if you sell on contract by carrying the paper on a sale.
The IRS determines real estate dealer status based on the intent of the taxpayer holding or buying the property. The characterization of gain or loss on the sale or exchange of real property turns on whether the property was held primarily for sale or for investment. The Tax Courts have come up with their top 15 items that they look at in determining the status:
- Taxpayer’s purpose for acquiring, holding and selling the property;
- Number, frequency, and continuity of sales;
- Duration of ownership;
- Time and effort expended by the taxpayer in promoting sales;
- Taxpayer’s use of brokers;
- Extent of improvements and amount of subdivision made to facilitate sales;
- Ordinary business of the taxpayer;
- Extent and value of the taxpayer’s real estate holdings;
- Extent and nature of the transactions involved;
- Amount of income from sales as compared with the taxpayer’s other sources of income;
- Taxpayer’s desire to liquidate landholdings unexpectedly obtained;
- Taxpayer’s overall reluctance to sell the property;
- Amount of advertising;
- Use of a business office for sales; and
- Taxpayer’s control over any sales representatives.
Of these, the most important issue appears to be the number, frequency, and continuity of sales. In other words, if you sell a lot of property, you might be considered a dealer simply because it appears that this is the type of real estate “investing” that you do.