Any investor who changes more than one or two properties a year will run into the problem of being rated “distributor status” by the IRS for tax purposes. This is extremely dangerous. Dealers, like real estate agents, are considered self-employed and are subject to self-employment taxes of 15.3%. Worse still, a dealership cannot pay taxes in installments when using owner financing. All taxes must be paid at the property in advance, even if all payment has not yet been received.
The most important factors that the IRS seems to use in determining whether or not someone is a real estate trader are the frequency of property sales, the number of properties sold in a year, and whether there is continuity in the process to suggest that they invest a property. it is the true intention of the business. If properties are held for more than a year prior to sale, this can also weigh against considering an investor’s activity as a “merchant.”
There are several ways to handle a significant number of transactions per year and still maintain the tax advantages of being an investor rather than a distributor:
1. Trade properties through a limited partnership, self-directed IRA, Coverdell education savings account, or individual 401k plan. In a limited partnership, only the general manager will be considered a distributor. Trusts and various types of self-directed retirement and savings accounts are considered passive investments, and these plans do not involve active participation in a business.
2. Form a joint venture agreement with an investor or active agent that will essentially create a “made-for-you” investment strategy for buying and wholesaling. That joint venture partner may well be considered a “merchant,” but as long as you or your entity are not under title, you will not be directly involved in any transfer activity.
3. Place each property in a separate LLC or trust and transfer the LLC or trust in place of the property that is within the entity.
4. At the very least, be careful to separate your investment and wholesale repair business from other business activities, such as your “buy and hold” operations or any deal that involves an installment sale.
Planning how you finance and maintain your property can be as critical in determining the success of your real estate investment as the actual selection of properties you decide to buy. Having the brand with dealer status could cost you a lot in the long run. Make sure you bid wisely!