For investors and business persons who sell property as dealers, such as a real estate developer who subdivides land and sells lots, the Clinton Tax Act has increased the importance of the distinction between investors and dealers.

If you are a dealer, any gain you realized would be taxed as ordinary income at rates up to 39.6 percent. Dealer status could occur, for example, where you subdivide real estate and sold and/or developed lots on a regular basis (real estate is not the only example of dealer versus investor status). If, however, you maintained investor status, the gain you recognized on the sale of your investment could be treated as a capital gain and thus would be taxed at the maximum capital gains tax rate of 28 percent.

Previously, the spread between the 31 percent maximum tax rate on ordinary income and the 28 percent maximum capital gains tax rate was not sufficient to influence the structure of many transactions. The Clinton Tax Act has changed this scenario. With an 11.6 percent tax differential in favor of capital gains, taxpayers will again go to great lengths to structure their activities and transactions in order to avoid dealer status.

For dealers in securities, additional complications of dealer status will affect tax planning.

The determination of whether you are a dealer or a mere investor is not simple. It depends on the facts in each particular situation. If you are involved on a regular basis in the development, improvement, and advertisement of property for sale, your activities will probably be characterized as those of a dealer. Where activities concerning the property rise to the level of a trade or business and the property is held as more than a mere investment property for passive income, dealer status is more likely. Development activities will not always rise to the level of a trade or business.

The determination whether a taxpayer's real estate activities rise to the level of a trade or business is a factual one, subject to a number of tests including the nature and purpose of the acquisition of the property, the duration of ownership, the continuity of sales and sales related activities over a period of time, the volume and frequency of sales, the extent of development or improvement on the property, the extent of soliciting customers and advertising, and the substantiality of sales compared with other sources of the taxpayer's income. Even if you are a dealer for some properties, it doesn't mean that you will automatically be treated as a dealer for all properties. You may have, for example, an active real estate development firm and own a separate parcel of property as a mere passive investment.

The best approach when you wear two hats is to isolate investment assets in separate entities from those that could be active businesses. For example, your real estate development activities could be conducted in an S Corporation while your investment property could be held in a separate partnership with different investors.

Suppose you have been lax in maintaining a clear distinction between dealer and non-dealer activities and properties. Can you change your status from dealer to investor? In limited situations, you may be able to. The task is not an easy one and will almost assuredly invite IRS scrutiny.



Source: the Real Estate Library

 

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