| Editor’s Note: I am pleased to announce the addition of Diane Kennedy, the nation’s preeminent tax strategist, as a new contributor to our Foreclosure Forecast ezine. Diane is the author of the Wall Street Journal and Business Week best-sellers “Loopholes of the Rich“ and “Real Estate Loopholes“ two new additions to my Recommended Reading list; owner of TaxLoopholes.com an online tax education company; and owner of DKAffiliatedâ„¢ a leading tax strategy and accounting firm in Phoenix, AZ. Enjoy our new Tax Strategist Columnist!
You may think you’re a real estate investor, but when it comes time for taxes, the name that the IRS may have another name for you. The IRS has four different designations for people who invest in real estate. Each one has a different tax angle. Where do you fit in?
One: Real Estate Professional
A real estate professional is someone who spends more time in real estate than any other activity and spends a minimum of 750 hours per year in real estate activities. This becomes an issue when you try to deduct your real estate losses against other income. If you make less than $100,000 in adjusted gross income per year, you can take $25,000 of your real estate loss against your other income. If you make more than $150,000 per year, you can’t take any of the loss against your other income.
Here’s where the real estate professional status comes into play. If you qualify, you can deduct all of your real estate losses; no matter how big they are, against all of your other income, no matter how much it is, if you are a real estate professional.
But, there are two catches to this right now:
- If you are subject to the Alternative Minimum Tax (AMT), you can not use the real estate professional loophole.
- The IRS is closely scrutinizing the Real Estate Professional status claim on tax returns.
To take the Real Estate Professional designation:
- Understand the rules
- Have good back-up proving the hours you work in real estate activities and the hours you work for everything else
- Have a contingency plan in case you’re subject to AMT
Two: Real Estate Dealer
The real estate dealer designation is one of the most misunderstood. If you’re a real estate dealer, it means that your real estate is a business, not an investor. For example, if you’re flipping properties, it’s the same as if you’re flipping burgers – it’s a business! You’re a dealer, not an investor. Contrast that with someone who picks up properties to hold on to for a long period of time to rent out. The landlord is an investor, not a dealer.
If you’re a real estate dealer, it means that you, just like any other business owner, are subject to self-employment tax if you operate in the wrong business structure. Unfortunately, this might mean an extra 15.3% in tax for the unsuspecting real estate dealer, who thought he was an investor.
If you’re subject to regular income tax, being called a real estate dealer can be a real problem. However, if you’re subject to AMT, being a real estate dealer means that any losses are deductible against your other income. If you’re an investor subject to AMT, you can not take the losses against your other income.
You may be a Real Estate Dealer if:
- You buy and sell real estate as inventory.
- You are a rehabber, wholesaler, or fix-n-flipper.
- Your intent when you buy property is to sell it quickly. (Contrast that with someone who buys property to rent and then changes her mind. She’s an investor, not a dealer!)
Three: Real Estate Developer
A real estate developer is someone who improves or changes a property before putting it into use. So, if you buy a piece of bare land, change the zoning, put in underground utilities and create a trailer park – you’re a real estate developer. The same is true if you buy a house and rehab it before you rent it out. You’re also a real estate developer.
The reason this is significant to the IRS is because you can not take any deductions for the property until it is put in use. In the examples above, that means until you start renting out spaces in the trailer park, you cannot take a deduction for the improvements (or depreciation of them), the property tax payments, utility payments or even the mortgage interest on the payments you make. And, just like with the trailer park, if you have a rental house that you are rehabbing, you can’t take a deduction for the improvements, mortgage interest, property tax and all the rest of the expenses until it’s ready to rent. These expenses are capitalized, which means turned into assets, that are later depreciated or amortized.
There is still one more problem with the real estate developer status. It’s a very tricky requirement called Uniform Capitalization (UniCap). Under UniCap, you also must capitalize administrative costs that you incurred while you were doing the construction. For example, you might find that you suddenly can’t take a full deduction for the cost of your office staff, office rent, computer costs and other purely administrative costs. Now, you have to capitalize them and only get to begin to amortize (take a partial deduction) once the property is ready for service.
The real estate developer status is definitely something you need to be aware of!
Some tricks to avoiding real estate developer problems:
- Put the property into service first and then improve or rehab it.
- If you’re definitely developing a property, look for the loopholes for UniCap. For example, you don’t have to capitalize marketing and financial costs. Turn your assistant into a marketing expert, and you kept the deduction for her salary.
Four: Real Estate Investor
And finally, there is the real estate investor status. It’s not so much a definition with the IRS, as simply “everything else.” Most people make the mistake of thinking they are an investor, when in actuality, they are a real estate dealer or developer. And, that’s where their tax planning goes wrong.
Get the latest news on what’s hot in tax strategies as well as tax-advantaged wealth building tips and resources at www.Taxloopholes.com.
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