Do you know the difference between dealer property and investment property? If you don’t then check out the following article. It goes over the differences between the two. The main difference that will interest you is the tax difference.
Basically, the IRS classifies any property purchased with the intent to immediately resale for a profit as “dealer” property, whether there is any rehab work done or not. Property purchased with the intent to be held for long-term appreciation and income (usually held at least a year or more) as “investment” property.
There are huge tax differences between the two.
If you purchase a house and turn around and sell it, whether wholesale or retail, your profit is considered earned income, subject to social security tax, and in the case of a sole proprietor, is reported on Schedule C of your personal return. After all federal, state, and social security taxes are considered, you could be looking at close to 50% total in taxes. If you purchase a house and rent it for at least a year or more, it is subject to capital gains tax, which is currently set at 15%, as opposed to earned income, and would be reported on Schedule E. This is why we typically hold onto our properties for at least a year, because of the tax benefits.
Paying 50% of your profits in taxes seems like a big loss, but if you need the quick cash, 50% is better than nothing, and we still recommend quick-turning some houses in the mix.
Through proper entity structuring, these taxes can be reduced somewhat, as discussed below.
Dealer properties are not allowed to take depreciation deductions, which you will see later is one of the biggest tax benefits for holding real estate. Also, if you owner-finance dealer property, all of the taxes on the profit is due in the year of the sale even if it is an installment sale. Owner-financing investment property allows you to take advantage of the installment sale tax treatment, which means you are taxed only on the income you receive for that year. Dealer property is not eligible for a 1031 Tax-Deferred Exchange, which is a topic outside the scope of this Manual, but it’s a big deal nonetheless.
The bottom line is that you don’t want your investment property (rentals or lease options) to be intermingled with your dealer property (quick-turns).
Unfortunately, the IRS doesn’t give us any specific ratios or numbers, but you could be classified as a “dealer” if you quick-turn a certain number of houses in comparison to the number of investment properties you hold, or even if your intent to quickly sell can be proven by how you advertise your properties.
If this happens, then all of your properties, even the ones held as investments for a year or more, would then be classified as dealer properties, and you would lose all the tax advantages we have discussed:%u2022 depreciation deductions%u2022 capital gains treatment%u2022 no social security tax%u2022 installment salesThe best way to avoid this potential is to keep your dealer properties in a separate entity from your investment properties.
You want to ensure that a “dealer” status is not attributed to what is really an “investment” property. Hopefully, the IRS understands that occasionally you will have a property in your “investment” category that you attempt to rent out or lease option, but a cash buyer comes along and buys the property outright. Again, the IRS looks at the intent, so if it ever came to question in an audit, you could show the intent to rent or lease option through your advertising and marketing efforts. The same goes for a “quick-turn” property that perhaps doesn’t sell as quickly as planned, so someone comes along willing to rent it from you. You could then “sell” it to your other entity that holds your investment property. The only caution in doing this, however, is to get with your accountant to make sure this “sale” is structured properly for tax purposes.
The preferred choice for these two entities is a corporation for your dealer, or quick-turn, properties, and a limited liability company (or limited partnership in some states) for your long-term investment properties.It may seem like overkill to form two separate companies just starting out, but believe us, you will see that the trouble and expense is very low, especially compared to the huge tax savings you will achieve by implementing this strategy.
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