Wholesaling not allowed in California?

[Dominique Stevens]

Good Morning!

I am a newbie investor and new to the Bigger Pockets community. What a wonderful site!

I have a real estate license and have been in real estate finance for several years, helping others to acquire real estate.

I now want to build my own portfolio of rental properties. I'm planning on starting by wholesaling some properties to build up capital.

Question: I was speaking to a colleague this week about my plan to acquire my first wholesale opportunity, and he told me that he'd found out, through a seminar, that in the state of California, the state frowns on wholesalers, and that if the state finds out that I've completed transactions via transferring title twice in the same day (to two separate entities), too many times, that they will consider me a "dealer" and that I will have to pay 35% tax on any real estate deals I conclude in the state for the rest of my life. I've never heard that technicality before.

Is there some California code preventing "dealing" or wholesaling in real estate that I'm not aware of? Maybe I should consult an attorney.

Thanks Bigger Pockets community..

[Bryan L.]

I don't know CA stuff, but with the IRS there is the issue of being classified as a "dealer" for income tax purposes. It has nothing at all to do with wholesaling "not being allowed". But rather, the IRS may consider you to have a schedule C business instead of schedule D short-term capital gains. My guess would be that the CA tax code may be similar. But, even so - that doesn't necessarily mean that wholesaling is frowned upon or not allowed. Many people speak of things of which they do not know. Realtors are bad about that.

For example - the other day I had a loan officer to tell me that seller-held-back second mortgages are now "illegal". Oh really? What government agency has the authority to tell me how I can and can not sell my property? What she really meant (I think), is that seller-held-back seconds are not allowed on properties that are financed with government backed mortgages like Freddie and Fannie (and possibly FHA, VA, etc). But that's a lot different from a blanket statement that seller-held-back seconds are "illegal".

[Jon Holdman]

Income from wholesaling isn't short term capital gains. Its ordinary income, just like fix and flipping.

[Ellis San Jose]

They are confused on how the wholesale process works. You can assign a contract without taking title.

I'm not a CPA but if you wholesale a property and receive income, it is taxed as ordinary income. I'm sure you don't mind paying taxes as long as you are making more money than not wholesaling.

Dealer status is an important matter so consult a CPA as to what entity you can use for wholesaling and which one for your rental business.

[J Scott]

Originally posted by Bryan L.:
For example - the other day I had a loan officer to tell me that seller-held-back second mortgages are now "illegal". Oh really? What government agency has the authority to tell me how I can and can not sell my property? What she really meant (I think), is that seller-held-back seconds are not allowed on properties that are financed with government backed mortgages like Freddie and Fannie (and possibly FHA, VA, etc). But that's a lot different from a blanket statement that seller-held-back seconds are "illegal".

Not to side-track the thread, but in many states, it *IS* illegal in some/all situations for a seller to finance a deal. This is based on the SAFE ACT laws enacted by the state.

For example, in Georgia, if I buy a house for cash through my business, I can't legally seller finance that house on a sale. Ridiculous, but true...

Not sure what the SAFE ACT laws in your state are, but your loan officer may very well be correct.

[Dominique Stevens]

Wow! What a wonderful resource you all are. From your comments I'm realizing this is a tax issue. I will consult with a CPA. Does anyone know where I can go to obtain examples of assignment offer letters? Thanks again ~

[Melodee Lucido]

Dominique,

When working with sellers I always work with equitable interest in the property through a Pure Option. In this way I am not acting as a broker and it is legal.

It is all spelled out in the Option that I intend to market the property for a buyer to take my place in the agreement and that I intend to make a profit.

In the beginning of my wholesaling I got scared because brokers I would call me and tell me that I was acting as a broker without having a license. They said I was breaking the law.

As far as taxing goes you can ask your financial expert but my understanding is you are taxed on this biz as you would on any other one.

Great success to you!

[Bryan L.]

@Jon Holdman and @Ellis San Jose - I'm not attorney or CPA, but the way that I understand it is that wholesaling or fix-and-flip doesn't necessarily and automatically throw one onto schedule C as a dealer. John T. Reed's book on real estate taxes was very eye opening. It seems that tax law is often not cut-and-dried. There's often a grey area that is open to interpretation. For example, if one flips only one wholesale deal in a year while they are working a full-time regular j.o.b., does that automatically classify one as a "dealer". Maybe not.

@J Scott - just my opinion here also on this one as well. But the SAFE act was forced on the states by the Feds. And the Feds have no constitutional authority to regulate commerce that is not interstate commerce. So, while the SAFE act is technically a state law, it was unconstitutionally forced on the states by the Feds in violation of the 10th amendment, and is therefore unconstitutional (especially if one is owner-financing a property to someone else who is from the same state). It's time that we all stand up and fight against our over-reaching governments, especially the Feds. By the way, in my home state of TN, I think the government still "permits" (like they have the authority to tell me how to sell my own property), anyway they permit me to o-f sell 4 per year. But still, I don't know of any local SAFE act police department, so who's doing the counting? How will they know? I'm not going to give them a call or anything.

[Jon Holdman]

@Bryan L. dealer status and the type of income are two different things. Capital gains tax is on investments. Investments held under a year, such as a stock you buy and sell in under a year or a rental house that you end up selling in less than a year, are subject short term capital gains tax. That's the same rate as ordinary income, but is not subject to SET. OTOH, Goods that are acquired with the intention of selling, like shoes in a shoe store, a house you're rehabbing or a property you buy and sell are inventory. The profit on those sales is ordinary income subject to both income tax and SET.

As I understand it, "dealer status" mostly affects installment sales. If the IRS decides you're a dealer you owe tax up front on an installment sale rather than as the money actually comes in.

And dealer status can be property by property. So, while doing one wholesale deal a year may not make you a dealer that income from the wholesale deal is still ordinary income. You might get away with calling it a short term capital gain (and avoiding SET), but I don't think that position will survive an audit.

[Bryan L.]

@Jon Holdman - that's the thing Jon. According to references cited in Reed's book, there have been cases that have survived an audit and cases that have survived in tax court. From my understanding of if, there are many issues related to taxes that are somewhat open to interpretation. I highly recommend Reed's book on the subject. And I highly recommend a CPA who specializes in Real Estate taxes.

This bears out the real root cause of the issue from the original poster. People often make statements as matters of fact such as "wholesaling goes on Schedule C", or "wholesaling is subject to self-employment tax", or "wholesaling is not allowed in CA", and people take that are run with it as fact. It would be better to say that "generally, wholesaling is subject to self-employment tax". Even so, some people will hear a statement like that and it gets repeated and passed on a few times, and then the next thing you know people are saying things like "the IRS has ruled wholesaling to be illegal", or "wholesaling is not allowed in CA".

[Account Closed]

Dominique: There is a 3.3% of sale price witholding that the state imposes when you sell a property you don't live in here in CA. If as a wholesaler you take title vs contract assignment this witholding could be more than your wholesale fee. Maybe this is what your colleague is referring to. Doesn't sound like it but some times these things get really confused. Never heard of a 35% tax, that sounds a little too much even for CA.

[J Scott]

Originally posted by Bryan L.:

@J Scott - just my opinion here also on this one as well. But the SAFE act was forced on the states by the Feds. And the Feds have no constitutional authority to regulate commerce that is not interstate commerce. So, while the SAFE act is technically a state law, it was unconstitutionally forced on the states by the Feds in violation of the 10th amendment, and is therefore unconstitutional (especially if one is owner-financing a property to someone else who is from the same state). It's time that we all stand up and fight against our over-reaching governments, especially the Feds. By the way, in my home state of TN, I think the government still "permits" (like they have the authority to tell me how to sell my own property), anyway they permit me to o-f sell 4 per year. But still, I don't know of any local SAFE act police department, so who's doing the counting? How will they know? I'm not going to give them a call or anything.

Absolutely no argument from me that the SAFE ACT is a ridiculous set of laws and at least appears from a layman's perspective to be unconstitutional in some respects (constitutional law is complicated and I'm smart enough to know that I know absolutely nothing about it). But, the fact is, it exists and even unconstitutional laws can land you fines (or in prison) as long as they're in effect.

Btw, I don't know about other states, but in Georgia, the "police" of the SAFE ACT is the Department of Banking and Finance. Though, in my experience, even they don't know the law very well. I called asking about owner financing last year, and the guy had to call me back the next day after doing some research to tell me that it was illegal for my business to owner finance a property but would be legal for me to do it if the property was in my personal name.

Personally, I'd be comfortable seller financing out of my business (even though technically it's illegal), as long as I had a mortgage broker involved to handle the paperwork. I think the risk of getting caught is small and the buyer would still be protected with the proper disclosures and documentation.

[Bryan L.]

Constitutional law can't be too terribly difficult judging by the most famous former constitutional law professor in our country.

[Phillip Trujillo]

@Account Closed So if one is wholesaling in CA, assignment vs. taking title is the way to go to avoid the 3.3% sale price tax imposed by the state?

I'll be moving to northern CA in about 15 months so this is of concern.. Thanks.

Phil

[Account Closed]

Originally posted by Phillip Trujillo:
@Account Closed So if one is wholesaling in CA, assignment vs. taking title is the way to go to avoid the 3.3% sale price tax imposed by the state?

I'll be moving to northern CA in about 15 months so this is of concern.. Thanks.

Phil

It's a withholding, not a tax. It's like when your employer withholds from your paycheck and you get it back at the end of the year to the extent it was overpaid. And it has nothing to do with wholesaling specifically. Anytime you as an individual, corps and multi-member LLC's are exempt, sell a house in CA, escrow holds back 3.3% of the gross sales price and sends it off to the franchise board if it is an investment property, i.e., it's not your primary residence. This will explain it better CA 3.3% Withholding.

The problem isn't that you are paying anymore tax than CA's normal extra high rates, it's that it can play havoc with your cash flow if you aren't careful.

Welcome to the land of sunshine! ... And the sun tax that goes along with it :)

[Ellis San Jose]

@Phillip Trujillo

Yes, there ways to address the 3.3% withholding, I recommend that you read the statute & get a firm understanding of the exemptions. Then consult with your CPA & attorney to utilize the most appropriate solution for your situation.