Sometimes real estate
investors get nasty little
surprises at tax time. It
happens when they discover
they really weren't
investors after all -- at
least not in the eyes of the
IRS. There are three
different definitions the
IRS uses to define taxpayers
who buy, sell or hold real
estate. Your tax treatment
will differ based on the
definition that the IRS
gives you.
These three
definitions are:
Real Estate Dealer
Real Estate Developer
Real Estate Professional
Now, let's look at
each of these in more
detail.
A real estate
dealer is someone who is
in the business of buying
and selling real estate for
short-term profits. A real
estate dealer is known by
other names: wholesaler,
flipper, or rehab'er.
Although the person gets the
label of "real estate
dealer," it's a decision
that's made based on each
property. It's possible to
be a dealer on one property,
but not on another.
The key question is
whether the property was
purchased to sell or
purchased to hold. If you
"flip' the property for a
short term property, it's
just the same as if you flip
a burger -- you have a
business. That means as a
real estate dealer your
income is subject to
self-employment taxes and is
taxed at the ordinary income
tax rate. There's one more
additional wrinkle, as well.
Normally when you sell a
property "over time" you can
take what's called the
"installment method" for
calculating tax due. You pay
tax only as you collect
payments. A real estate
dealer can not take the
installment method. That
means if you're considered a
real estate dealer for a
property that you sell and
carry back paper on, you'll
pay tax on the whole profit
now -- whether you've
collected any money or not.
The second definition
is real estate developer.
A real estate developer is
someone who renovates or
changes the use of a
property. It could be the
person who buys an apartment
building for a condo
conversion, the developer
who turns bare land into a
trailer park or simply the
person who buys a wrecked
house and does extensive
work before it's habitable.
The tax challenge for
a real estate developer
occurs when he or she
remodels or constructs a
property.
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Costs that are incurred
during the time the property
is in development must be
capitalized and later either
expensed or amortized when
the property is put in
service or sold. Just
imagine: You might be paying
mortgage interest, property
tax, construction costs, and
other property related costs
and not be able to deduct a
dime of it.
The tax news gets even
worse still, though. As a
real estate developer, you
also must capitalize your
"indirect costs." This
includes administration,
management and just the
ongoing costs of running a
business.
That's what happened
to Jack and Sue when they
expanded their rental
business to include business
development. They bought a
piece of land to be
developed into a trailer
park. They grumbled about
the fact that they couldn't
take a current deduction for
the interest and property
taxes paid for the trailer
park. They even knew that
they couldn't take a
deduction for the costs of
developments. The bad tax
surprise occurred when they
discovered that the cost of
their rental office was now
not completely deductible.
Their office secretary, for
example, fielded calls
related to the construction.
That meant part of her
salary had to be capitalized
into the trailer park as
well. There is a cost to
development and it isn't
always the obvious cost of
the bills you pay for the
development. It also
includes the additional tax
burden you'll have during
the development.
The final
classification is "real
estate professional."
Finally, we have an IRS
definition that will put
money in your pocket. A real
estate professional is
someone who is involved in
real estate activities and
owns 5 percent or more of
his or her business. If the
real estate professional is
employed somewhere else, he
or she needs to spend more
time in real estate
activities than the other
employment and a minimum of
750 hours in real estate. If
you're a real estate
professional, you'll be able
to take a full deduction for
any real estate losses
against your other income.
A rose by any other
name would smell as sweet,
Mr. Shakespeare tells us.
But a real estate investor
with the wrong name could
cost you big time in taxes,
the taxman says. |
