Sometimes real estate investors get nasty little surprises at tax time. It happens when they discover they really weren't investors after all -- at least not in the eyes of the IRS.
There are three different definitions the IRS uses to define taxpayers who buy, sell or hold real estate. Your tax treatment will differ based on the definition that the IRS gives you. These three definitions are:
- Real Estate Dealer
- Real Estate Developer
- Real Estate Professional
Now, let's look at each of these in more detail.
A real estate dealer is someone who is in the business of buying and selling real estate for short-term profits. A real estate dealer is known by other names: wholesaler, flipper, or rehab'er. Although the person gets the label of "real estate dealer," it's a decision that's made based on each property. It's possible to be a dealer on one property, but not on another.
The key question is whether the property was purchased to sell or purchased to hold. If you "flip' the property for a short term property, it's just the same as if you flip a burger -- you have a business. That means as a real estate dealer your income is subject to self-employment taxes and is taxed at the ordinary income tax rate. There's one more additional wrinkle, as well. Normally when you sell a property "over time" you can take what's called the "installment method" for calculating tax due. You pay tax only as you collect payments. A real estate dealer can not take the installment method. That means if you're considered a real estate dealer for a property that you sell and carry back paper on, you'll pay tax on the whole profit now -- whether you've collected any money or not.
The second definition is real estate developer. A real estate developer is someone who renovates or changes the use of a property. It could be the person who buys an apartment building for a condo conversion, the developer who turns bare land into a trailer park or simply the person who buys a wrecked house and does extensive work before it's habitable.
The tax challenge for a real estate developer occurs when he or she remodels or constructs a property. Costs that are incurred during the time the property is in development must be capitalized and later either expensed or amortized when the property is put in service or sold. Just imagine: You might be paying mortgage interest, property tax, construction costs, and other property related costs and not be able to deduct a dime of it.
The tax news gets even worse still, though. As a real estate developer, you also must capitalize your "indirect costs." This includes administration, management and just the ongoing costs of running a business.
That's what happened to Jack and Sue when they expanded their rental business to include business development. They bought a piece of land to be developed into a trailer park. They grumbled about the fact that they couldn't take a current deduction for the interest and property taxes paid for the trailer park. They even knew that they couldn't take a deduction for the costs of developments. The bad tax surprise occurred when they discovered that the cost of their rental office was now not completely deductible. Their office secretary, for example, fielded calls related to the construction. That meant part of her salary had to be capitalized into the trailer park as well. There is a cost to development and it isn't always the obvious cost of the bills you pay for the development. It also includes the additional tax burden you'll have during the development.
The final classification is "real estate professional." Finally, we have an IRS definition that will put money in your pocket. A real estate professional is someone who is involved in real estate activities and owns 5 percent or more of his or her business. If the real estate professional is employed somewhere else, he or she needs to spend more time in real estate activities than the other employment and a minimum of 750 hours in real estate. If you're a real estate professional, you'll be able to take a full deduction for any real estate losses against your other income.
A rose by any other name would smell as sweet, Mr. Shakespeare tells us. But a real estate investor with the wrong name could cost you big time in taxes, the taxman says.
