Choosing the right tax strategy depends on understanding your options and how those options are shaped by the way certain activities are characterized or treated for tax purposes. The tax code is full of tests that determine how activities are characterized and how gains or losses are treated. Following are important tax concepts that should give you the vocabulary necessary to make the most of the strategies available to all tax savvy real estate investors.
#1 Realization Versus Recognition
The most fundamental tax concept for real estate investors to understand may be the difference between realization and recognition of gain. Gain or loss is usually realized at the time a property is sold or exchanged. Gain or loss is recognized when it is included in or deducted from gross income for tax purposes. We usually think of realization and recognition as occurring simultaneously. Earned income from wages or self-employment is typically realized AND recognized in the year in which it was earned.
Real estate investing offers a unique opportunity to separate the timing of recognition from realization. The primary goal of several strategies I cover in my consultation with our clients is to delay the recognition of gain. For example, in a like-kind exchange a taxpayer may realize gain when he exchanges one property for another, but the real estate investor does not recognize or pay taxes on the gain at the time of the exchange.
Here is a simplified example
Mark purchased an investment property five years ago for $300,000. He plans to sell it now for $500,000. Upon the sale he will realize a $200,000 gain. This realized gain will also be recognized, and he will owe approximately $30,000 in taxes. However, if Chris exchanges the property in a like-kind exchange, instead of selling it, he will still realize a $200,000 gain but will not have to pay the $30,000 in taxes since recognition is delayed until a later time.
#2 Adjusted Basis
Another important concept real estate investors need to know is adjusted basis. Adjusted basis is important because it is used to determine your taxable gain or loss. Taxable gain is the amount you realize from a sale or exchange of property that is more than its adjusted basis. The adjusted basis of a property is your original or cost basis plus certain additions and minus certain deductions. A buyer’s cost basis can be summarized as the buyer’s cost to purchase the property. The cost basis includes amounts paid in cash or other assets and certain debt incurred. It also includes broker commissions, closing and title fees, and capitalized legal and accounting fees. Adjustments to the cost basis are made over time for certain costs incurred, like capital improvements and depreciation.
#3 Investor Versus Dealer
The label you are given by the IRS can have a significant impact on your bottom line and the tax strategies available to you. Real estate investors need to know the difference between investor and dealer activities. In most cases, the best tax rates and advantages go to investors.
Unfortunately, investor versus dealer status is one of those murky areas that get tax professionals tongue tied. We think of a dealer as someone who holds property primarily for sale to customers in the ordinary course of his trade or business (for example, a subdivider or developer). An investor, on the other hand, is someone who holds property primarily for appreciation.
There are no hard and fast rules, but following are some of the more common factors that the tax courts have used to decide whether someone is an investor or dealer:
- Number of sales activities. A person who makes multiple sales in a single tax year may appear more like a dealer.
- Primary intent for which the property was acquired. Your intent at the time you bought the property is a big issue for the IRS, even though it is very hard to know what is in someone’s mind. If you intend to hold the property for appreciation, you are probably an investor. If you intend to resell the property, you are probably a dealer.
- Activity of the owner in connection with the sales. Regular and ongoing advertisements make you appear more like a dealer, as does having a business office dedicated to sales.
- Nature and extent of owner’s other business. If your primary source of income is from property sales, you appear more like a dealer. If you have another business that rises to the level of being an occupational undertaking, then you look more like an investor.
- Extent of improvements made to the property. Making extensive improvements, such as subdividing, paving, or utilities, to the property may signal that the taxpayer bought the property for resale and is a dealer.
The label is important since different tax rates apply to investors and dealers. Investors get to apply the currently lower long-term capital gain rate on gain from the sale of properties held longer than one year. In contrast, dealers must normally pay ordinary income tax rates on gain, which could also trigger self-employment taxes. In addition, certain tax strategies are only available to investors. Only investors can qualify for like-kind exchanges or installment sales tax treatment.
The investor/dealer label is applied to each property transaction, so individuals who are normally dealers can be investors with respect to a particular property. For example, a building used by a dealer in his trade or business may be considered an investment. Of course, someone who is normally a dealer will have a harder time proving that she is an investor.
Should the IRS challenge your claimed investor status, you have the burden of proving that you are indeed an investor. Keep good notes and records that reflect your intent at the time you purchased the property. Organizational documents for entities that hold property should reflect your investment purpose. In a partnership, for example, the partnership agreement could include an investment purpose provision. Most importantly, before you take a position on whether you are an investor or dealer, meet with a qualified tax advisor.