Real Estate Dealer vs Investor!

Individuals who frequently sell real property must determine whether they are real estate dealers or investors. The distinction is important because dealers and investors are treated very differently for tax purposes. 

Real Estate Dealer Defined

Real estate dealers buy and sell properties as part of their regular business operations, with profits taxed as ordinary income and subject to self-employment tax. A real estate dealer’s holdings are inventory for sale to customers, the same as any merchant’s inventory. 

Real estate dealers typically include (but are not limited to)

• Real estate flippers who buy homes, fix them, and then resell them quickly.

• Real estate speculators, who buy and sell a large amount of real estate each year;

• Subdividers, who purchase large tracts of vacant land, divide the tracts into smaller lots, and then resell them piecemeal; and 

• Real estate developers and home builders who construct new houses and resell them soon after completion.

  
  

Real Estate Investor Defined

Real estate investors purchase and hold properties primarily for long-term appreciation or rental income, typically enjoying favorable tax treatment such as capital gains rates and depreciation benefits. Unlike dealers, they sell their property infrequently, usually after a long holding period.  Real estate held for a long time and appreciates in value with minimal improvements is likely an investment. Typically, improvements made are primarily aimed at increasing the rental value, rather than earning profits from a quick sale.

Differences in tax treatment

Dealers and investors receive very different tax treatment, as discussed below:

Dealer Advantages:

• Dealers may fully deduct losses as ordinary losses.

• They also deduct real estate selling expenses, such as commissions, fees, and advertising, as ordinary and necessary business expenses.

  
  

Dealer Disadvantages:

• The dealer pays taxes at ordinary income tax rates, up to 37%. Additionally, they pay self-employment tax on their profits.

• They also cannot deduct depreciation on their properties because the properties are considered inventory.

• Dealers can’t use section 1031 to exchange properties. Neither can they use the installment method to report property sales. 

  
  

Investor Advantages:

• Investors pay capital gains tax on their profits and can qualify for long-term rates of 0%, 15%, or 20% if they hold their property for more than one year. 

• Investors do not pay self-employment tax. 

• Investors can depreciate their rental properties.

• They are also eligible to use section 1031 for the exchange of properties and the installment method to report property sales.

  
  

Investor Disadvantages:

• Investors can deduct no more than $3000 of their capital losses from ordinary income (after offsetting gains against losses)

• Investors are automatically subject to the passive loss rules.

  
  

Note that there are both positive and negative aspects to each classification; however, being classified as a dealer is generally not advantageous tax-wise.