Real Estate Dealer vs Investor Well It Depends
There are substantial tax consequences to being treated as a dealer versus an investor when determining how to account for real estate transactions. How do you determine if a taxpayer is a dealer or an investor?
The taxpayer may have both property held for investment and as inventory to sell in the ordinary course of business. Initially, it must be determined if a particular piece of property is held primarily for sale in the ordinary course of business. The Supreme Court defined primarily as meaning “of first importance”. How one determines the purpose of the property sold as a dominant part of taxpayers’ course of business is a matter of facts and circumstance.
When real estate developers buy and sell property as part of the ordinary course of a “trade or business”, they are considered dealers not investors. If considered a dealer, then the taxpayer will not be permitted capital gain treatment on the sale of such property. The Tax Court considered the following factors in determining whether property is held as part of the ordinary course of “trade or business”:
- The purpose for which the property was acquired.
- The purpose for which it was held.
- Improvements, and their extent, made to the property by the taxpayer.
- Frequency, number and continuity of sales.
- The extent and substantiality of the transactions.
- The nature and extent of the taxpayer’s business.
- The extent of advertising to promote sales (or lack of advertising).
- The listing of the property for sale directly or through brokers.
The above factors are applied to each specific property sold and in question, rather than the activities of the taxpayer.
The following activities were found to constitute those of an investor and, therefore, warranted capital gain treatment on the sale of property:
- Income Test: The amount of gain created by a real estate transaction versus the income from an individual’s daily activities.
- Activities Test: Were measures taken to plot, subdivide, or improve the properties. Minor investment activities acceptable.
- Sale of the property is not due solely to the improvements to the property
- Market factors vs. property improvements play a large part to the disposition of the property
- Sales Solicitation Test: Properties are not advertised for sale; nor are “for sale signs” placed on the properties or brokers used to sell properties. Sales are the result of a purchaser’s initiation.
- Sales Frequency Test: The number of properties sold within a given time period. The Tax Court determine nine properties in four years did not constitute a business. Continuity Test: Engagement in a business requires “regular and sustained” versus “intermittent and occasional activities”.
- Time Test: The normal working time spent on career activities is greater than the amount of time spent on real estate transactions.
- Facilities Test: The taxpayer does not maintain a separate office to transact real estate activities. In addition the taxpayer is not a licensed real estate broker or associated with a real estate company.
With the bulk of the above tests documented the taxpayer can qualify as an “investor”.
Change of circumstances can also dictate whether a property was held for investment or whether the property is held as inventory for sale. Proof in the change of circumstances and intention can determine the success of changing a property from “dealer” property to “investor” property. In one case, the intention of the taxpayer to develop land to residential builders was changed by the state in its determination that the land was condemned and could not be developed. The taxpayer than changed the plans for the land and when the property was sold the gain was taxed at capital gain rates.
One of the more frequent causes of change in circumstance is due to unforeseen financial trouble. In a court case, the financial difficulties of the land development corporation, prompted creditors to place restrictions on the company’s activities. The creditors strongly recommended that the company leave the development business and sell the land without solicitation. The court determined that the property concluded its intention of being held for sale to the public in the ordinary course of business. The result of gain from the land sale was not due to the owners’ development or promotion but due to the elapse of time and natural amassing.
Conclusion: There is no fixed formula to determine whether a property is held for development or investment. The facts and circumstances of each transaction and the documentation of the taxpayer’s activities are critical.