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What is "dealer status" in real estate? In this live, we'll discuss how to avoid dealer status on your seller finance deals.
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What is dealer status and how do you get that designation?
If a real estate investor goes into a deal with the intent to sell the real estate, they can and likely will be considered a "dealer" in the eyes of the IRS. This status does not apply to all of your deals, but is considered on a deal by deal basis.
Examples of activities considered dealer activities would be fixing and flipping and wholesaling real estate. This is considered active income, not rental income and subject to dealer status. Dealer transactions are taxed differently than investment income. Investor status is taxed as capital gains, dealer status is taxed as ordinary income PLUS self-employment tax (15%+).
This rule also applies to installment sales and unfortunately, dealer status means that you are taxed on the ENTIRE gain. Here is an example:
Let’s say that you bought a house in January at $100k (this is your cost basis). You then sold that property to an owner-occupied buyer on installments for $150k. You have a $50k gain in that transaction. Maybe you took a down payment of $10k and you’ve received principal and interest payments of $800 / month for the entire year.
Your tax basis IS NOT your down payment and the principal / interest income. Your tax basis for that year is $50k!
Example:
Let's say you’re in the 30% tax bracket. That means on that $50k gain, you will pay (ballpark) $15k in ordinary income, PLUS an additional $7600 in self-employment tax (FICA - Social security and all of those wonderful “benefits” brought to you by your federal government). If you have zero deductions, your tax liability on $50k of earnings would total out to over $22k, but you’ve only taken $19,600 in income on the property. Do you see the problem here?
"But Jeff, don’t you sell all of your properties on installment sales?
Yes! All of my SFR properties are sold on installments. (contract for deed, mortgage wraps, etc.)
The question then becomes “how do you avoid being tagged as a dealer in your business?”. The short answer is… I DON’T.
You have to think about the activity you’re doing and plan for its tax ramifications. One of the benefits of being tagged as a dealer is that you get to take deductions on your activities, so you can decrease your tax liability through those deductions.
Here are my recommendations / suggestions on how to avoid dealer status on your real estate deals:
1. Hire the right tax professional. Make sure you’re tax strategist or CPA understands real estate and has a large investors customer base.
2. Just like your flips or wholesale deals, you get to take deductions in the form of business expenses on each deal. Take as many deductions as you possibly can to offset your earnings and, ultimately your tax liability. Think capital purchases that you can depreciate over time, fix up costs, materials, utilities, etc. (all of the same deductions that you take on a regular flip).
3. Sell your property on a lease-purchase or lease-option. Rent the property for 12-18 months before seller financing. This establishes your intent to rent the property.
4. Start a C-Corp and let the C-Corp be the dealer since C-Corps only pay 21% in taxes
Do the math on all of your deals! The math doesn't lie. If your tax liability is greater than the income generated in 1-year's time, you may want to reconsider the seller-financing model.
