SMALL BUSINESS TIPS
How Will Your Real-Estate Sale Be Taxed?
When you sell real estate property other than your primary residence, the tax implications of that sale depend on whether it qualifies as dealer or investor property. Each of these classifications is taxed differently and carries its own benefits and drawbacks.
Dealer Property: Property you hold for sale to customers in the ordinary course of a trade or business is considered Dealer Property. House flipping is a common example of dealer property because you purchase the property with the intention of fixing it up and selling it for a profit.
Profits on dealer sales are taxed at your ordinary income rate which can be as high as 37 percent and are also subject to the self-employment tax of 15.3 percent. Dealer sales cannot be used in 1031 exchanges to defer taxes by reinvesting in another property.
One advantage of dealer sales is that any losses on a property are considered ordinary business losses which can be fully deducted in the year of the sale as opposed to capital losses on investment property which are limited to $3,000 per year.
Investor Property: Property that is held to produce income or long-term appreciation is considered Investor Property. Rental properties are the most common type of investor properties.
Profits on investor sales are taxed at capital gains rates which are capped at 20 percent if you own the property for more than one year. Investor property sales are also not subject to the 15.3 percent self-employment tax.
The cost of investor properties can also be depreciated over the useful life of the property, although the depreciated cost will need to be recaptured at the time of the sale. Investor properties qualify for 1031 exchanges which allow you to reinvest the profits from the property into a similar property and defer the taxes on the sale until you sell the new property. One disadvantage of investor property sales is that the deduction for capital losses is capped at $3,000 per year unless you have capital gains from another sale to offset the losses.
Generally speaking, if you sell a property at a gain you will receive favorable tax treatment if the property is classified as investor property and if you sell a property at a loss you will receive favorable tax treatment if it is classified as dealer property.
Classifying Your Property Sale
Identifying the correct property classification is not as simple as determining which will give you better tax treatment. In classifying your property sale the IRS will look at multiple attributes of the individual sale and your overall situation:
Intent: One key area the IRS will look at when classifying your property sale is your original intent in purchasing the property. If you purchase a property with the intent of fixing it up and reselling for a profit, then that property is considered dealer property. If you buy a property with the intention of fixing it up to operate as a rental property it will be considered investment property. Even if you sell the property before collecting any rent you can classify it as an investment property if you can demonstrate that your original intent was for it to be a rental property. Documenting your intent at the point of purchase is critical to defend your position before the IRS.
Holding period: Generally speaking, the less time you own a property before selling it the greater the chance the IRS will classify the property as a dealer property.
Frequency of property sales: If you are regularly buying and selling properties you are likely to be classified as a dealer.
“Making a Living:” If a significant portion of your income is made through buying and selling properties you are more likely to be classified as a dealer.
These attributes are examples of what the IRS looks at to classify your property sale but not a definitive list. There is no standard formula to follow and you need to evaluate the characteristics of each property sale on its own. Understanding the distinction between a dealer and investor property can help you avoid surprises in tax season. Proper planning and record-keeping can also ensure that you receive the best tax treatment available to you when you sell your property.
For help determining how your property sale should be classified, please reach out to us.