Avoiding “Dealer” Status When Flipping Houses
The 411 on Wholesaling and Dealing …
When it comes to real estate wholesaling, those two words may make a tax attorney smile, but they most likely will cause you to throw up in your mouth a bit.
(At minimum, the words “dealer status” probably make you uneasy…and for good reason.)
Not only is “dealer status” one of the most common concerns that my mentoring students have, it’s also a highly litigated topic among real estate investors.
The reason? Investors use different strategies that each require different tax treatments. Here’s what I mean …
When investors sell their properties on a lease-option or contract for deed, the gains accrue over several years. In some cases, we’re talking decades. As a result, the “paper profits” from these deals never come to fruition, which directly impacts the tax consequences from these types of sales.
Now let me state up front that there is no official test per se for determining whether an investor is a “dealer” (don’t get happy just yet) – but there are definitive factors that the IRS considers when trying to label you as either a “dealer” or “wholesaler”.
And just in case you need a reminder – wholesaling real estate is simply placing a property under contract at a significant discount before immediately reselling it, or assigning your contractual rights to another end user or investor at a discount. (The difference between significant discount and discount is your profit as the wholesaler. A typical wholesale transaction happens within a 30-day period, but I have seen some last up to 12 months.)
Here are some of those factors I mentioned, which the IRS considers when defining your status as a “dealer” vs. “wholesaler”:
- Purpose of the acquisition
- Length of ownership
- Number of transactions by investor
- Proportion of income from real estate sales
- Frequency of sales
- Amount of gain realized
- Nature of advertising for the properties
Bottom line of it all is this: You can cross into the “danger zone” in a variety of ways, including (i) if you are a flipper, (ii) if you are primarily a landlord, (iii) if you sell most of your properties on land contract or lease options, and (iv) if you’re primarily a flipper with some rentals on the side. Conforming to any of these factors may cause you to face significant amounts of unexpected taxes, interest, and even penalties as a dealer.
But consider these things in light of both their bad news and their good news:
First, the Good News
So far this blog post feels like a real Debbie Downer, but chin up! You can control (to come degree) how much you’re impacted by the dreaded “dealer status”.
Firewall: If you plan on owning rentals, keep them away from the entity with which you wholesale.
Corporate Architecture: If you plan on making wholesaling a profession, try setting up an LLC to be treated as an S-Corp., because it isn’t a pass-through entity like a standard LLC – so you won’t incur a self employment tax or any other suck factors that come with being a dealer.
Legal Advice: If you plan to wholesale, consult with your CPA or tax attorney to prepare for the “dealer status” backlash.
Teamwork: Rely on your team, the professionals who surround you, to help design your business to maximize profits and minimize tax penalties.
Now, the Bad News
Remember I mentioned 12 months above, in reference to the maximum amount of time for a wholesale transaction (based on my own personal experience)? When investors sell a property within 12 months, they are subject to short-term capital gains that are taxed in their individual tax brackets. If not for the “dealer” status, this would ring true.
Treasury Regulations Section 1.402(a)-4 defines a dealer as “a person who is engaged in the business of selling real estate to customers with a view to the gains and profits that may be derived from such sales.”
In short, you are like any other business that sells widgets, so you’re taxed a 15.3% self-employment tax, which is added to your personal tax bracket.
And as if that wasn’t already cause for alarm, here are some other disadvantages to being classified as a “dealer”:
- Depreciation: If you hold rental properties in the same entity through which you conduct your wholesaling activities, you will lose the ability to take depreciation (because they will view your rentals as inventory).
- 1031 Exchange: You cannot use a 1031 Exchange to redirect your profits into another investment.
- Deferred Income: And here’s the kicker: You cannot “defer income” if you use creative seller financing to sell the property over time (which is a huge tax benefit to an installment sale). Instead, you would need to take the entire tax hit immediately.
And not to pour anymore salt on your wounds, but there is no set of transactions or guidelines that can classify you as a dealer, as I mentioned. Your business is at the mercy of the IRS, who simply conducts an “Intent Based Test”, in order to review your history, purpose, frequency, time & effort, extent of involvement, and profit – just to name a few factors.
Knowledge is Power, and That’s a Silver Lining!
I know. I feel your pain.
Being labeled “dealer” is a major bummer, no doubt.
But here’s more good news: Now you’re armed and empowered to better prepare for the financial impact that “dealer” status can have on your business.
Use today’s lesson as a reference. Let it marinate for a while, and then start focusing on making and saving money by wholesaling real estate.
Invest smarter, flip smarter.
Plan ahead, and you just might be able to avoid getting caught in the “tax trap”.
Keep it real, keep it classy
Tags: Dealer Status
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