Dealer Status Attached To Person, Entity, Or Transaction
Oops... I know I've read the answer to this several times, but I forgot it, and I'm not finding it right now...
Is "dealer status" applied to an individual, or a transaction? In other words, does the IRS say "Joe is a dealer, so ALL of his transactions will be treated accordingly" or do they say "Joe has done a few flips (with intent to flip) so they are dealer transactions, but he also has some rentals, so they will be treated as investor holdings and he may 1031 them, etc.
OR... and this is the part that I think got me confused in the first place: Does the IRS assign dealer status to an ENTITY. so Joe could have an entity (C-corp) in which he purchases with intent to flip, and also have several llc's, etc in which he may deal as an investor, 1031 them, etc. If this is the case, then can having one entity pegged by the IRS cause others to suddenly have taxes due by being redesignated?
OR... (always a possibility) do I not have a clue what I'm talking about, and have I missed it entirely?
I'm not an expert in other areas of the tax code, but I can address this from a 1031 exchange perspective. The dealer status is attached to the taxpayer/exchangor. So, if Joe would be viewed as a dealer by the Internal Revenue Service then Joe does not qualify for 1031 exchange treatment on any of his properties. I have seen some very creative strategies to get around this, but none of them have been challenged and the IRS has not issued any substantive guidance to clarify the issue.
From what I understand the easy answer is that it depends on the transaction. You should definatly consult a professional here as the IRS tax code is too long for most anyone else to give you a qualified answer.
GOOD LUCK
My understanding, and I am by no means close to being an expert is:
If Joe is classifird as a dealer then the type of transactions that caused this classification would be taxed accordingly. Other types of REI could be consider as investments not inventory.
For example, Joe regularly flips houses. The IRS may see houses as Joe's inventory and therefore classify Joe as a dealer. Any profits Joe makes from flipping houses would be treated as income. Joe also buys office buildings as long term investments. If Joe sold an office building, any gain would be treated as capital gain and not income. Joe would also be elligible to do a 1031 exchange with the office building.
Again, this is only my understanding on how dealer status works. Consult your accountatnt to be sure.
The last posting is not correct. If the investor/taxpayer is classified as a dealer then they do NOT qualify for 1031 exchange treatment on any of their properties.
http://www.thecreativeinvestor.com/modules.php?name=News&file=article&articleid=429
Thx. I had read the article already... and every bit I could find on this site and others, and I've got to say there is a LOT of confusion over this issue. After asking several questions on the subject, I have come to the conclusion that the only thing that counts is finding actual cases that have weathered the IRS storm.
I have heard everything from "If you do anything in RE other than landlording, you are a dealer, so deal with it and move on" to "You can flip houses all day long and never be a dealer by..."
The opinions are all over the place. I would think that if your regular course of action was to sell on CFD, you'd be toast. (Not necessarily bad... again, I'm just trying to understand the BIG picture which includes, among other things, the tax implications.) If you sold on L/O, I would think you'd be all-right (if the contracts were worded properly)... however, I've gotten lots of opinions on this as well.
Not that I would ever enter into a transaction for the "tax benefits" alone, but the difference in taxation SHOULD be one indicator in choosing an optimal strategy.
The problem I am seeing is that very few people have an answer at all. The most common response is "No-one knows, so go see your RE tax professional." The problem with that is that most of the people who gave the conflicting accounts in the first place GOT their info from their RE tax professional.
I care less about who is saying the advice than what the true source is... does anybody know of IRS tested cases that indicate the validity of any of these strategies?
Let's start basic. Do you believe Joe in the following account to be an investor or a dealer, and why? (I'll start with a simple case, then as we move forward, I'll add a couple of the twists that caused me to ask the question in the first place.)
Joe buys houses, then immediately sells them on 2-year L/O's. Some of them close within 2 years. Some don't. Those that don't, he finds another TB and repeats the process. Joe has no other source of income, and does not sell or rent houses in any other fashion.
Is joe a dealer or an investor? Why?
This is definatly a dealer activity because you are buying and selling property. Just as a builder may build and sell spec homes you are doing something similar.
You are right in that as a dealer you cannot use the installment method of reporting. This does result in a potential problem in that you must pay tax on money you don't have!
You may want to seek a qualified tax professional and talk to them about the possibility of using the "percentage of completion" accounting method. In a nutshell from my layman's perspective, you take the stance that the transaction is only 25% completed (or whatever) and only pay tax based on that. I have not used this before but I've kept this limited knowlege in my toolbox for the time where this may be useful.
I'm not claiming to have all of your answers and you are right that most accountants don't understand tax law. Most people do not realize that accounting principals and tax principals are very different. A tax strategy is a very niche area and there are very limited people that truely understand what they are doing.
My tax guy has always told me that it is my job to make the money and his job is to help me keep the money I make.
GOOD LUCK
Quote:Is "dealer status" applied to an individual, or a transaction? In other words, does the IRS say "Joe is a dealer, so ALL of his transactions will be treated accordingly" or do they say "Joe has done a few flips (with intent to flip) so they are dealer transactions, but he also has some rentals, so they will be treated as investor holdings and he may 1031 them, etc.I am going to disagree with those who suggest that dealer status is attached to the individual. I base my argument on the Internal Revenue Code definition for a dealer disposition. In accordance with IRC Section 453(l)(1)(B)A Dealer disposition is any disposition of real property which is held by the taxpayer for sale to customers in the ordinary course of the taxpayer's trade or business.By inference, the taxpayer who engages in this trade or business is a dealer to real estate.
This suggests to me that the individual is not tagged as "dealer" but the "dealer disposition" tag is applied to the transaction. In other words, the IRS evaluates each transaction to determine whether it is a dealer disposition.
The problem that Joe might encounter with engaging in both dealer dispositions and investment sales at the same time, is that he runs the risk of having his dealer dispositions taint his investment activities. If Joe has established a pattern of activity with the preponderance of his sales treated as dealer dispositions, then the IRS may determine that all his property sales are dealer dispositions (even the investment property sales).
The issue is intent. Conducting all your activities (both dealer dispositions and investment property sales) from within the same business entity suggests that your primary purpose is to always hold your property for sale to customers (even though you may rent out a property during your holding period). Maintaining separate business entities and separate bank accounts helps establish a firewall between the "dealer" entity and the investment entity.
Quote:OR... and this is the part that I think got me confused in the first place: Does the IRS assign dealer status to an ENTITY. so Joe could have an entity (C-corp) in which he purchases with intent to flip, and also have several llc's, etc in which he may deal as an investor, 1031 them, etc. If this is the case, then can having one entity pegged by the IRS cause others to suddenly have taxes due by being redesignated?Yes, Joe can have multiple entities, each engaged in a separate investment strategy. For example, if Joe conducts all his dealer dispositions in a S-Corp and holds all his rental income property in an LLC, then the S-Corp's dealer dispositions do not taint the LLCs investment property sales. The LLC can freely profit from a 1031 exchange while at the same time, a 1031 exchange is denied to the S-Corp.
Unfortunately, this is what I expected... completely divergent views... and I guess the point I was trying to make is that some of these views are probably based on talks with individuals who supposedly have this rarified knowledge. Therefore, I would likely get a different answer depending on which "expert" I went to and paid handsomely.
I've had a number of accountants. Some told me everything I wanted to hear. Some were afraid of their own shadows. Unfortunately, I find it nearly impossible to find a reasonable criteria with which to measure the accuracy of information I receive in this area.
The only thing I can think of is a lawyer who deals specifically with tax law as it relates to Real Estate. Even then, such a highly concentrated specialist is bound to charge me lots of $ and be interested in protecting his income, so everything he says has to be taken with a grain of salt.... just like my accountant who tries to make everything sound complicated so I'll do all my corps and filings through him.
I'm not sure if this sounds crazy or not, but I'm starting to come to the conclusion that it makes MORE sense to broadcast the question in search of as many unsolicited opinions as possible. In a forum such as this, many people share their experiences and lessons learned, and in the course of disagreeing with eachother, common ground is sometimes found.
Since noone that answered this thread has a financial stake in causing me to believe one way or the other, I'd rather get as much information as possible this way before attempting to judge the credability of a so called "expert" in the field to help http://www.me.the i's and cross the t's.
That being said.... Dave, assuming you are correct (and I have no Idea if you are, but yours seems closest to the opinion I had formed... for whatever reason) What disposition would be assigned to Joe's L/O transactions as described in the previous post? (By the way, I'm starting out with L/O's as his only form of income, and the only type of transaction he does so that the L/O question is answered independently of structuring issues, etc.)
By the way... thanks to everyone who's participating here. It's the discussion that I find most valuable. Even if an "expert" chimed in and gave all the right details in exactly the correct fashion, without the discussion, we'd have no way to evaluate it as such.[ Edited by thestudentisready on Date 05/24/2004 ]
L/O investing is a grey area. This means that some aggressive tax advisors might push the envelope and have the taxpayer claim investment tax treatment for all his L/O dispositions.
I have the opposite viewpoint. I assert that the taxpayer is still engaged in dealer dispositions if his only business is L/O. The fact that he puts each property he acquires under a lease option agreement is sufficient evidence for me to assert that the taxpayer has the requisite intent to sell each property he acquires. While intent is sometimes difficult to prove, the taxpayer is at a disadvantage in tax court because the taxpayer must prove that the IRS position is wrong and that his intent is NOT to sell the property.
If the taxpayer is in a sandwich lease option -- he does not actually own the property he is lease optioning to a tenant buyer -- then the taxpayer has NO way to avoid dealer disposition tax treatment.
I set up two LLC's, one for the rental property and the other for flipping. It was my understanding that having the two entities would prevent IRS from taxing me for income I had on paper but not yet received. In addition, my 1031 transactions on the rental property would be safe from capital gains. Erich 8-)
Student I feel your pain. Your last post above is exactly how I feel. I even called my CPA today and told him I was confused on the subject of dealer status. He knows I have many RE holdings. His answer, how ever noncommittal as it was, was that he would feel better if I used other entities for longer term holdings.
I think the problem lies within the IRS itself. They aren't going to make it cut and dry and box themselves in. It will be decided on a case by case basis. Stinks huh?
Has anyone been clasified as a dealer and got finded by the IRS? What are the risk? There is a big difference between the longterm capital gains rate and ordinary income rates.
pspiers,
There is no designation of "dealer status". At some point in time, the IRS does not come along and say "Henceforth, you are a dealer".
Instead the IRS looks at your pattern of past activity and says your past transactions were dealer dispositions. They recharacterize your past transactions, recompute your tax returns, add up your back taxes, add penalties and interest, then they ask "How will you be paying your bill?"
Oh, by the way, your self-employment income taxes have not been paid either. So your tax bite could be quite large.
DaveT
I should have phrased my question like this. Has anyone had any of their past transaction reclassified by the IRS? What was the outcome?
It Has been my understanding that if your transactions were outside "the ordinary course of your trade or business" then the IRS could not reclassify your transactions. Therfore, a full time job would be your "trade or business" and RE would be investing. Joe's "trade or business" is flipping houses. Joe invests in office buildings. I understand that Joe still may have problems with the IRS depending on the pattern of his office building trnasactions.
I guess the real question is how far can you push the envelope on how you define your "trade or business" and how you define your investing?[ Edited by pspiers on Date 05/25/2004 ]
And this is the reason I start with the assumption that Joe is doing L/O's ONLY, and is NOT working anywhere else or receiving other income. I think a lot of people get confused on some of the points here because there are so many variables. I'm just trying to eliminate them one by one to see where the REAL distinctions are.
So: If Joe sells on L/O. Joe has no other job. Joe has no other RE transactions. He just buys Sub2 and sells on 2 yr L/O's carefully worded so the option consideration does not reduce the sale price, and neither do the rental payments, either through "rental credits" or any other method. If he has made as clear a distinction as he reasonably can between the lease contract, and the option contract... if the IRS were to audit Joe's REI activities, what disposition would be assigned in this case?
Once THIS point is understood, then it will make sense to see what the ramifications of other income, multiple entities, etc are... but right now, I've done a couple of weeks worth of searching, and I'm not sure I have a clear answer to even this most fundamental question. If you're planning on making your living this way, I'd think it would be insane to charge ahead without knowing the answer here, because if you turn out to be wrong, and the IRS retroactively reclassifies all of Joe's deals, invalidates his 1031's, etc... it could bankrupt him.
My guess is that the separation of the two contracts, the short term of the L/O, and the absense of correlation between equity / purchase price and option consideration / rent would be enough to clearly demonstrate that this is investment activity as no sale is effectuated within the first year.
However, am I missing something? Does Joes lack of another income invalidate this point? If so, what if he were a landlord ONLY? Is there anything else I'm missing?
student,
I can only reiterate my previous response to you in this thread.
I assert that Joe is still engaged in dealer dispositions if his only business is selling each Subject To property he acquires on L/O. The fact that he puts each property he acquires under a lease option agreement is sufficient evidence for me to assert that the taxpayer has the requisite intent to sell each property he acquires. While intent is sometimes difficult to prove, the taxpayer is at a disadvantage in tax court because the taxpayer must prove that the IRS position is wrong and that his intent is NOT to sell the property.
In a nutshell, Joe is still flipping property -- just using a L/O as his exit strategy. Dealer disposition tax treatment still applies in my opinion.
pspiers,
Your job is your occupation. Property flipping in your spare time is an active income business.
Investment property is defined by the IRS as property held by the taxpayer for the production of income or for future appreciation. Purchasing "investment property" is an investment activity -- not usually an active income trade or business.
For real estate, a dealer disposition is defined by the IRS as ANY disposition of real property held primarily for resale to customers. A dealer disposition is also declared by the IRS to be an active income activity -- in other words, a trade or business..
Perfectly clear to me. In my mind the envelope is clearly defined.
DaveT
Thanks for your replies to this thread.
I can see your point. However, I have read about and paid for advice on many different stratagies on how to keep the IRS from clasifing RE transations as dealer activities. Now, I don't know what to believe.
Student is right. If you are an investor you need to know the risk. I guess with your approach you don't have to worry about paying back taxes, interest and penalties.
What is the old saying? "It is unethical, immoral, and ilegal to evade taxes; but, it is your respoinsibility and duty to avoid paying taxes".
Here are two better quotes from the Honorable Learned Hand, US Appeals Court Justice There are two systems of taxation in our country: one for the informed and one for the uninformed.
Over and over again Courts have said there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich and poor, and all do right, for nobody owes any public duty to pay more than the law demands. Taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.Even Albert Einstein complainedThe hardest thing in the world to understand is income tax!And finally, J M Keynes, doubtlessly one the most important figures in the entire history of economics opined
The avoidance of taxes is the only pursuit that still carries any reward
Sorry, Dave.
Your first response to my L/O question somehow got lost in flipping pages on here... Something about choosing page 1 or 2 to jump to, then flipping back... the "page breaks" sometimes shift... anyway...
I would very much like to know, though, if there is any case that shows reclassification based upon the L/O. The only example of this I have seen had several other issues clouding the L/O to begin with. This is, of course why I was specific about the wording and term of the L/O.
Perhaps you can help me to understand something... I have read now many times that the option consideration when selling on L/O is not taxed until execution or termination. Therefore, clearly the IRS does not see a sale as taking place until the option is exercised. I would think that this fact alone would qualify the L/O as an investment activity. After all, how is this different than if I intended to lease the house for two years, then sell it?
I can, however, see the argument that even though the sale did not take place in year one, the INTENT of the transaction (and ultimately the acquisition in the first place) was to create a sale... regardless of the time required to execute. If, however, I had simply leased it for two years first, my initial transaction would have been an investor move, and I could easily claim that I had no intention of selling in two years, but things changed, and... well, I would think that the separation of the two would make it too dificult for the IRS to prove dealer intent at the time of my acquisition.
What confuses me is that I have read a number of times (unless I simply hallucinated this... always a possibility) that if a "dealer" does an L/O, then he must do the accounting differently and, among other things, pay taxes up front on the option consideration.
If, as you assert, "dealer" status is assigned on a per transaction basis, and IF (and that's a big IF) I am properly understanding the two different tax treatments of an L/O, then...
Wouldn't EVERY L/O that anyone does automatically have the taxes due in the year the option is received? After all, if EVERY L/O is a "dealer" transaction, and if the IRS says that "dealer" L/O's must be accounted for using this other method (which I really don't understand yet, so if I'm confused, this is probably where)... Well, if that's the case, then I no L/O would ever be able to defer the taxes by definition... (transitively anyway.)
A=B, B=C, so A=...
Or have I misunderstood some point. If so, maybe this will clear it up for me...
If I do a L/O and account and pay taxes as an investor (no taxes on option cons. until execution), but the IRS later audits me and reclassifies the L/O as a "dealer" transaction, when they begin to add-up the sum I will have to pay in back taxes, interest, penalties, etc. will their calculations be based on the fact that I should have paid taxes on the option consideration in the year it was received, or the year it was executed? (If I've misunderstood this portion, it would explain a lot.)
Student:
I think that Dave's response is pretty clear and also corresponds to the practice in the industry as far as I know.
"Dealer" status attaches to the transaction. I, for example do both industrial condo conversions (clearly a dealer transaction) and long-term land plays (clearly not) and rental property (also not). We treat each transaction accordingly for tax purposes. I suppose I could put together separate entities to do each different kind of transaction but while that might help clarify borderline cases it would not change the essential principle.
I do not know anyone who has had this treatment overturned by the IRS, that doesn't mean it hasn't happened, only that I haven't heard about it. But I think my method is the normal practice. So if there were problems I think I would have heard.
Student,
i think we have beat this horse enough. Your latest question is hijacking this thread and diverting the discussion to a new topic. I will be happy to address the tax treatment of option consideration or even lease options in general, both as a dealer disposition and as an investment property disposition.
Please post your questions on this new topic as a new thread.