Investor vs. dealer status.

• Author: Matherly, Benjamin
• Position: Real estates ventures

In today's hot real estate market, many taxpayers are recognizing significant gains when disposing of their real estate holdings. With the large disparity in long-term capital gain and ordinary income tax rates, most taxpayers are seeking capital gain treatment. However, the appropriate treatment depends on the taxpayer's status as either an investor or dealer of real estate. "Dealer" in the context of this discussion, is a term commonly used to describe a person who holds real property "for sale" rather than for investment.

Real property will not be deemed a capital asset if it is "held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business" under Sec. 1221 (a) (1) (hereinafter described as being "for sale"); thus, gains or losses on real property held for sale will be ordinary in character. If the property is not deemed for sale, the gains or losses will be capital (or, in the case of depreciable rental property, a Sec. 1231 gain or loss). To qualify for the preferential long-term capital-gain rates, the property must be held for over one year.

Held for Sale or Investment?

There is no bright-line test to determine whether property is held for sale or investment. Some factors the IRS considers when determining the property's status are:

* Purpose of the acquisition and period held;

* Taxpayer's efforts to sell the property;

* Extent, continuity and substantiality of sales;

* Extent of subdividing, developing and advertising to increase sales;

* Character and degree of control exercised by the taxpayer over any representative selling the property; and

* Time and effort the taxpayer devoted to the sales.

The more frequent the sales, the more time and effort spent on sales; the shorter the period the property is held, the stronger the case for dealer status (see Phelan, TC Memo 2004206, discussed in Sartain, Tax Clinic, "Capital Gain on Development Property" TTA, December 2004, p. 734).

As mentioned above, an obvious disadvantage to dealer status is that it subjects gains to ordinary tax rates. Other disadvantages are the inability to use the installment sale method and Sec. 1031 tax-flee like-kind exchanges. By contrast, dealers can offset losses against ordinary income with fewer restrictions than capital losses. Also, property held for sale is not subject to Sec. 163(d)'s "investment interest" limits; under Sec. 163 (d)(5), only property held for investment is subject to Sec. 163(d).

Strategy

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