Posted by Mark Campbell on July 17, 2002 at 07:08:33:
Thanks for your help.
tax issue coverage in courses - Posted by Mark Campbell
Posted by Mark Campbell on July 15, 2002 at 15:26:12:
I am just starting my REI education and was wondering if the tax issue is covered very thoroughly in all of the courses. That is the one area that I have the most concerns about. Any advice would be greatly appreciated.
Re: tax issue coverage in courses - Posted by Ronald * Starr(in No CA)
Posted by Ronald * Starr(in No CA) on July 15, 2002 at 21:48:10:
Mark Campbell--------------
There are several books that specialize in that topic. You might find some on amazon.com or by calling your local bookstores. It is possible a local public library might have such a book. I can recommend John T. Reed’s “Aggressive Tax Avoidance for the Real Estate Investor.” It is one of the best real estate investing books on any topic, in my opinion. Try his website johntreed.com . This is for long-term hold rental investors.
If you do just quick-turn real estate, buying and selling soon for a profit, you will never have to study the tax ramifications of real estate for your own taxes. There is none. All quick resale properties are taxed at your ordinary income rate, all in the year of sale. Nothing special to study there.
Good Investing****************Ron Starr***********
Re: tax issue coverage in courses - Posted by Mark Campbell
Posted by Mark Campbell on July 16, 2002 at 09:18:31:
Thank you Mr. Starr for the insight. I am looking at the quick-turn side of the REI coin.
The article that initially got me to raise this question was called “Tax Alert” by John Hyre. He used an example concerning a quick-turn type situation that looks like it would make a seemingly good deal go bad due to a tax situation. The article is on this website, but I copied it below so if you wanted to read it you wouldn’t have to look for it. Thanks again for you help.
Mark
Are You a “Dealer”
Or an “Investor”?
by John Hyre
This article is about what makes a real estate investor a “Dealer” for federal income tax purposes. We are not talking about the requirements to be a state licensed mobile home or real estate seller. Nor are we talking about the guys and gals in Las Vegas who take all of your money in exchange for “free” booze. Instead, we are focusing on a classification that dramatically affects how much tax is paid and when it is paid.
Why the “Dealer” Issue Matters
Congress is most discriminating. For example, if two investors each purchased adjacent and identical properties for exactly the same price, spent exactly the same on improving each property and sold the properties for the same price to the same buyer, one investor might pay double the taxes of the other. And the difference in taxes paid would be even larger when measured in terms of present value.
Specifically, a property acquired and later sold by an “Investor”:
Generates depreciation deductions;
Is taxed at favorable capital gains rates when sold;
May qualify for deferral of gain under IRC Section 1031;
May qualify for deferral of gain as an Installment Sale.
The same property sold by a “Dealer” is simply taxed at full ordinary rates upon sale, with no deferral and no depreciation deductions. Sometimes simpler is not better.
Are You a “Dealer” or “Investor”?
Congress differentiates between the “identical” situations described above based upon the intent of each investor. Generally, if an entrepreneur purchased a property with the intent to sell, then he would be a Dealer with respect to that property. If, on the other hand, the entrepreneur purchased the property with an eye toward holding it for the income and appreciation benefits, the more favorable Investor status would apply.
That’s right, the same outfit that is consistently unable to distinguish between “Trust Fund” (Social Security in theory) and “Pork Piggy Bank” (Social Security in fact) wants to know what you were thinking when you bought that property. Maybe Dealers need better lobbyists.
Fortunately, technological capacity is not quite up to the demands of Congressional mind-reading intent, so we can keep our tinfoil helmets in the closet. Unable to peer into one’s head, the IRS must make do with peering into one’s business. The courts and the IRS consider the following factors in determining whether a real estate entrepreneur is a Dealer:
Duration of ownership. Properties held for less than two years will likely be treated as dealer inventory. Properties held for more than two are often, but not always, treated as investments.
Manifestations of intent. Statements of intent will be held against you if resale ideas were expressed. A firm representation made to investors of intent to buy and hold may be of some slight help.
Extent and nature of efforts to sell the property. Strong and constant advertising, use of agents and personal sales efforts are the hallmarks of dealers. However, this factor is rarely fatal, because investors liquidating property must also advertise and use brokers. Basically, the more constant and intense the activity, the greater the likelihood that this factor will point towards an intent to sell.
Number, substance and continuity of sales. The greater the number of sales over time, the more likely a sales intent exists. This factor alone can be fatal to investor status. This factor is also neutral at best–a lack of sales does not necessarily indicate a lack of sales intent (just a lack of skill or luck!).
Extent of subdivision and development. Subdivision and development tend to indicate an intent to sell, though subsequent sustained rental of developed properties may nullify this factor.
Use of a business office for the sale of property. Not generally an important factor, but it can tip the balance in close cases.
Degree of control exercised over selling agents. A close degree of control over agents gives the appearance of a sales operation. This factor is rarely applied in practice.
Time and effort habitually devoted to sales. This factor is more properly part of the third factor described above. The more habitual the effort, the more likely a sales intent exists.
Which Factors are Most Important?
Nobody–including the courts–knows. Number of sales, duration of holding, and extent and consistency of sales efforts seem to weigh most heavily. However, this area is very heavily litigated and the court opinions are all over the map and sometimes inconsistent.
If homes are advertised and resold within two years on a pretty consistent basis for cash or on Contract for Deed (Land Contract), you are almost certainly a Dealer. The lines are a bit more murky where lease options are concerned (more on that below). Personally, I think Dealer status is like the Supreme Court’s definition of pornography–you’ll know it when you see it, all pretenses at “art” & “Investor status” aside. The amount of litigation in this area is intense, which means that the IRS is quite aware of the issue and willing to fight it. Expect scrutiny on audit.
Important Planning Issues
The first priority is to ensure that Dealer status is not attributed to non-Dealer properties. For example, if an investor held some rentals with her “flip” properties, the rentals could easily end up tainted as Dealer property when sold. One pretty certain means of segregating Dealer and Investment properties is to put each class of property into different entities. Generally, the dealer properties go into a corporation and the investor properties are placed in an limited liability company or limited partnership.
However, contrary to popular belief, one can also hold Dealer and non-Dealer properties in the same entity while preserving the favorable tax status of the latter. The key is good documentation to prove the segregation between the property types. Using separate entities to segregate the property types is the safer approach, but holding them in one entity is still feasible for those who cannot afford multiple entities from the get-go.
The Dealer classification is especially troublesome where contract-for-deed or land contract (CFD/LC) transactions are concerned. Remember that Dealers may use neither the installment sales method nor enter into tax-free exchanges, so any tax on a sale is due when the sale is made. Because a Dealer selling on CFD/LC takes payments instead of cash, he may have to go out of pocket to pay income taxes.
For example:
Investor purchases property for $50,000 cash;
Investor sells property on CFD/LC for $100,000 with $7,500 down;
Assuming a 31% bracket, the tax due equals $15,500 ($50,000 gain x 31%).
Our Dealer would have to go $8,000 out of pocket ($15,500 tax due less the $7,500 down payment received) just to pay Uncle Sugar? and that doesn’t include Social Security or State income taxes! That sort of hit could turn a good pre-tax return into a dismal after-tax return.
Solution: Aggressive use of the cash method of accounting could help defer some of the tax hit if the note would hypothetically sell at a large discount on the market. Be sure to document examples of note sales to back your position!
Even better, use lease options (L/O’s). Taxation on the option consideration should be deferred (even for dealers) on well-structured L/O’s. Lease payments are included in income as received. Sale proceeds are taxed if and when the option is exercised. To ensure that a lease-option is not treated as a CFD/LC and taxed immediately, it must be carefully structured (That topic could easily fill another article.)
For aggressive taxpayers, L/O’s with low exercise rates may avoid Dealer status altogether. Basically, the taxpayer could argue that the options are present to attract good tenants, as opposed to good buyers, and that few of the tenants in fact exercise their options. Viola, few sales and no intent to generate them! Overall, well-structured L/O’s provide superior tax deferral opportunities when compared to CFD/ LCs. Of course, the tax benefits of L/O’s must be weighed against any business or legal downside when compared to CFD/LC’s?.decisions, decisions!
What Not to Do
Last, but not least, some investors claim that less than five (or seven, or whatever) sales per year exempts one from Dealer status. Based on this theory, some investors create multiple entities and ensure that each entity conducts no more than five (or seven, or whatever) sales per year to avoid ever being classified as a Dealer.
This technique is bogus from a legal standpoint. ONE sale with the intent to sell is all it takes to be a Dealer. No magical “safe-harbor” number exists. Upon audit, the IRS can look through the pretense of multiple “non-Dealers” and reclassify ALL of the transactions as Dealer sales? and levy the appropriate penalties.
Whether one is a Dealer depends on intent. That intent is judged, in part, by the total number of deals done over time. For example, if you did one deal in year one and ten deals per year for the next ten years, the year one transaction would be treated as a Dealer transaction.
I repeat. There is no minimum number of sales required to be a Dealer!
In summary
Dealers are treated much worse than Investors by Congress and the IRS;
“Flippers” and most investors that regularly sell properties (regardless of number) for cash or on CFD/LC are Dealers;
There is no “magic number” that makes you a Dealer- just one sale can be a Dealer sale if the necessary intent is present; and
The well-planned use of L/O’s and the aggressive use of the cash method of accounting can take some of the sting out of the Dealer rules.
About the Author . . .
John Hyre is a tax attorney practicing in the following areas of federal and state income taxation: Real Estate, Partnership, Corporations and International. He has worked for several Big Five accounting firms and Fortune 500 companies. His clients range from small real estate investors to multi-billion dollar corporations. He has saved his collective clients tens of millions in tax dollars. John says, “Keeping as much money as possible from the IRS is both fun and lucrative!”
John currently invests in mobile homes (“Lonnie Deals”) as well as the land (lots) under the homes. He loves the high returns and the hassle-free management on the dirt. He resides in Ohio with his wife, Carolina, and children, Alexandra and John.
John is also the co-host of our Legal Corner.
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Re: tax issue coverage in courses - Posted by Dave T
Posted by Dave T on July 16, 2002 at 21:47:14:
I think you misunderstood the thrust of Mr. Hyre’s article. Nowhere in the article is there an allusion to a “a seemingly good deal go bad due to a tax situation”.
No one ever goes broke taking a profit – even after taxes. Mr. Hyre is simply trying to initiate the uninformed on the difference between “investment property” and “dealer realty” and the difference in the tax treatment on the sale profits from each.
Once you understand the tax treatment, then you can be fully prepared for the tax consequences should you decide to sell your flip property on a Contract For Deed or an installment sale. If you know that you will have to pay all of the tax on the profit in one lump sum, you (1) can employ other tax avoidance strategies to offset your tax bite, or, (2) pay the full tax when due because you have set aside a large enough cash reserve, or, (3) make sure you collect a large enough down payment to cover your tax bill, or, (4) finance the tax bill with the IRS, and pay them on the installment method, or, (5) only accept offers that cash you out so you will have the money in hand to pay the tax due.
Mr. Hyre’s point is to make you aware of the tax treatment of certain REI strategies so that you will can be prepared when the tax man cometh.
Re: tax issue coverage in courses - Posted by Ronald * Starr(in No CA)
Posted by Ronald * Starr(in No CA) on July 16, 2002 at 12:40:54:
Mark Campbell-------------------
I am an investor. I held one property for 26 years before I sold it. I have a couple of properties I bought in 1988, so that is 14 years and counting.
I have sold a few properties pretty quickly. Just makes them ordinary income or, if I held for more than one year, long-term capital gains.
When I buy, I let everybody know that my plan is to hold as a rental into the foreseeable future. I never could understand why people were talking about having an “exit strategy.” Then I figured it out–my exit strategy is to die siezed of my rental properties. Just try to stop me!
Good Investing*Ron Starr