When most investors think about business planning for their real estate investments, their main focus tends to be strictly on asset protection. However, there is a genuine need to also focus on potential adverse tax consequences depending upon the type of real estate transactions that you have targeted for your investing strategy. Wholesaling properties falls within this realm. Typical investors will often enter into a wholesale in their own name since they are not concerned about asset protection because of the short holding period. Unfortunately, they are oblivious of the severe tax consequences that loom in the shadows.
Real Estate Wholesaling & Dealer Status
To give you a little background, a wholesale transaction is a deal entered into for profit in which title will transfer into the investor’s name and then be sold within a twelve month period. Investors generally believe that the gain on the property will only be treated as short term capital gain and thereby taxed in their individual tax brackets. The investors would be correct if it wasn’t for the “dealer” classification. A “dealer” in real estate is defined in Treasury Regulations Section 1.402(a)-4 as a person who is engaged in the business of selling real estate to customers with a view to the gains and profits that may be derived from such sales. There is no magic number on the number of transactions you have to do before getting classified as a dealer. Unfortunately for investors this is strictly an intent based test and therefore the burden will be placed upon investors to prove that they are not dealers.
Implications of Dealer Classification
If the investors do get classified as dealers, there is a litany of negative tax consequences that will follow:
- The income earned from the investment will be treated as earned income and thus subject to a 15.3% self-employment tax that will be added on to their own personal tax bracket;
- Investors will no longer be able to capture the depreciation on their rental properties because the rentals will be view as inventory by the IRS and inventory is not subject to depreciation;
- Investors will no longer be able to enter into 1031 exchanges; and
- Investors will lose the ability to defer income recognition on installment sales.
These are tax consequences that generally want to be avoided at all costs.
It is clear that investors do not generally want to be classified as dealers, but what business entity should they use for the wholesales? If the wholesale occurs through a limited partnership, the dealer classification will attached to the general partner. If the investor is the general partner there is no tax benefit in using a limited partnership. Often investors will structure the deal through a single member LLC that is disregarded for tax purposes. However, since the LLC has no separate tax structure the dealer status will flow down directly to the single member of the LLC. Wholesale transactions are one of the few times that we want to have real estate within our corporations.
Implications & Protection
From a tax standpoint, a corporation, or an LLC that has elected to be taxed as a corporation, is perfectly suited for an investor’s wholesale activities. Since the sale of the wholesale occurs out of the corporation, the dealer status will not be attached to the owner of the corporation or the member of the LLC that is taxed as a corporation. Whether or not you use a “C” or “S” corporation is an issue that I would raise with your accountant or attorney because there are a variety of factors that should be addressed when determining the best tax structure. It is very important that title of the wholesale be immediately transferred into the corporation and that the sale occurs through the corporation. Many investors will take title personally, rehab the property, place the property on the market and then transfer title to the corporation immediately before sale. This would be viewed as a tax motivated transaction by the IRS and would be disallowed on audit.
The dealer tax classification is truly a trap for the uninformed investor. Thankfully, this pitfall is easily avoided through proper business planning. There is not a one size fits all solution for all investors, each transaction should be entered into in an informed manner, not only in terms of asset protection, but also in regard to the tax ramifications.
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