The Importance of Dealer Status in Real Estate Investing

In this episode of the Tax Smart REI Podcast, Ryan discusses dealer status when selling property with Tax Advisor, Nathan Sosa, CPA. They explore what it means to have dealer status, the tax implications involved, and how the IRS evaluates these cases.

Dealer Status: Difference Between Investor and Dealer

The differences between an investor and a dealer are found in their intentions and activities. An investor typically holds property for cash flow and long-term appreciation, facing a maximum tax rate of 23.8%. While, a dealer frequently buys and sells properties, often with the intent to flip them quickly, and may be subject to ordinary income rates, potentially reaching up to 52.3%.

Winthrop Factors to Determine Dealer Status

The episode delves into the Winthrop factors, a set of criteria used to determine if someone should be classified as a dealer. These factors include the nature and purpose of property acquisition, efforts to sell the property, the number and frequency of sales, the extent of development work done, the use of a business office for sales, control over sales representatives, and the time and effort devoted to sales. The most crucial factor is the frequency and continuity of sales, which heavily influences IRS evaluations.

The Importance of Documentation in Dealer Status

Ryan and Nathan explained the importance of maintaining consistent classification on tax returns and documenting the plans for each property.

Having clear documentation can support your case in IRS audits or tax court.

Additionally, separating flipping and investment activities into different entities can provide further clarity and protection.

Dealer Status Recent Developments

The episode highlights recent court cases where the IRS has aggressively challenged taxpayers’ classifications.

Some taxpayers have found themselves classified as dealers despite having limited sales history, underscoring the need for meticulous documentation and clear intent.

Final Recommendation

Nathan emphasized having a clear plan and documenting the intent for each property. All documentation must align with actual activities and circumstances. Partnering with a tax advisor like Nathan can help navigate complex cases. Request a consultation with our team here.

Continue reading for the episode transcript.

Transcript

Intro

Ryan: Today, I’m joined by Nathan Sosa, a tax adviser here at Hall CPA, to discuss what it means to have dealer status when selling a property. This is a heavily audited topic in recent years, so if you’re curious about what factors the IRS will consider when selling a property to help you ensure you pay capital gains taxes and not ordinary income taxes, you’ll love this episode with Nathan.

Background

Ryan: All right, we are here with Nathan Sosa. Nathan, you have joined us in the past on episode 267, back again to talk about a new topic. We’re talking about things like being a dealer and the Winthrop factors. We’ll get into what that is in just a little bit, but before we do, would you be able to give our listeners just a little bit of background on who you are?

Nathan: For sure, Ryan. Yeah, thanks for having me on again. So, I have been in Oklahoma City for like the past two decades, honestly, so definitely an Oki at heart. It’s getting real hot out here. I don’t even know if it gets warm in Minnesota, Ryan, so I’m not sure what you’re experiencing at the moment, but yeah, love talking tax, love talking real estate. Honestly, anything that comes to that’s like basically investing or anything like that involves tax strategy, it’s definitely like a fun topic for me. Voracious reader, so like always reading tax report cases.

And also, as you can see, you can’t really see the podcast, you can’t see the books behind me, but like all the books behind me as well, so definitely something like that. Also trying to find sleep, you know, we got a nine-month-old right now, so that’s lots of fun. But I tell everybody not lots of sleep, but yeah, that’s a little bit of background on me.

Dealer Status Topic

Ryan: Awesome, well, thank you for that. And for those of you listening, Nathan is kind of a typical tax nerd is what he has self-said of himself, and I would absolutely agree. There’s a few of them in the world and he is certainly one of them. So, he is a good person to hear some technical things like what we’re going to talk about today, which is kind of talking about things that we in the profession would call the dealer status. And we’ll kind of get into again another phrase that is out there, we’re going to evaluate the Winthrop factors, and that comes from a tax court case where they’ve kind of outlined some various factors, seven I think in particular, of factors that help someone who is, for example, an owner of real estate.

How do we determine, how might the court determine whether an individual selling a property is essentially considered a real estate investor or someone who is a dealer who is then going to be seen as more of like a flipper, and there are some tax differences there, some very specific tax implications between those two and how you’re seen. So Nathan, can you just kind of give us a broad overview of what are the main differences there as far as the tax aspects, the various percentages, but also just like, yeah, other than the tax implications, is there anything more that people should really be considering here other than this tax difference? But yeah, walk us through some of that.

Dealer Status vs. Investor Status

Nathan: Yeah, absolutely. So like one of the first things to think about is that if you are an investor, the largest tax you can get on a sale of your property will be 23.8%. You know, just think about it like you’ll send a quarter of it to the IRS, right? Highest you’ll ever do if you’re an investor. However, if you are considered a dealer, then the tax rate you could be subject to, if you’re going to be subject to the highest rates, right? You do got a great property, great appreciation on it, and now you’re selling it. You could be subject to the highest ordinary income rates, which is 37%, and self-employment tax, which means that on that sale alone you could be potentially subject to basically a 50% tax, right?

So we’re looking at basically a 25% difference in the money you get to keep versus the money that you’re sending to the government, right? So trying to delineate between these lines is incredibly important, right? And sometimes the line is like, sometimes it’s really clear, right? Sometimes you fall really, you’re really far on the investor side, makes sense, right? No big deal there. Or you completely fall on The Flipper wholesaler side, right? So no big deal. Sometimes we kind of land in the middle, and that’s where we can really find value for clients and find the opportunity to take advantage of certain aspects and have forward planning and forward-thinking, right? That’s the goal here, is to be thinking and looking forward to how we can help our clients save on that 25% rate right there.

Factors to Consider

Ryan: Right, yeah, there’s huge tax differences as far as the tax rates, the various taxes that someone’s going to be impacted by between whether you’re just a real estate investor when you sell your property, right? You’re thinking long-term capital gains potentially plus net investment income tax, so that’s kind of how we got to the 23.8%. And then the 52% that Nathan’s talking about is that highest federal income tax rate of 37% plus that assuming all of it’s, you know, potentially subject to self-employment tax, that additional 15.3%. So that’s kind of how you get to the 52.3% there. So that’s a huge difference, right? Double, more than double between these two differences. So this has huge impacts for any of you looking to sell.

We’re in a market where people are considering selling or maybe some of you are just holding on until rates change maybe next year. Well, you’re going to be wanting to Think Through early on before a sale, hey, what might I need to be doing or protecting myself from some pitfalls here to make sure that when I do sell this next year or coming up this year to make sure that I don’t fall into that 52% and maybe more likely stay to that 23.8 if I were ever to be audited. So Nathan, let’s just kind of keep continuing on here. What is an investor in real estate? Let’s just kind of start there. How do we start to make these distinctions?

Who is an Investor?

Nathan: Yeah, an investor is someone like the tax code and tax court cases kind of looked at someone that’s like if you are an investor, you’re holding the property, right? You’re looking for cash flow, you’re looking for rental income, right? That’s what you’re looking on, looking for rental income and appreciation, right? Like obviously, like we’re all diversifying our portfolios, like we’re investing into, some people do stocks, some people do bonds, some people also want to diversify and put themselves into real estate, right? They want to get the appreciation on real estate, whatever that ends up being over time, while getting cash flow at the same time. And as we talk about all the time, the beautiful tax benefits that we get alongside it, right? So that’s an investor, right?

Who is a Dealer?

Now, on the quote-unquote flip side, no pun intended, is the flippers, right? People who are buying a property, whether it’s, you know, it’s a dump or it’s almost ready to market, but you know, you could sink in another 10 to 15,000 and you might be able to get 30, 35 out of it, right? So like something like that, like someone who’s like, hey, I’m going to work on this for six months and then sell it after six, right? That’s someone who’s going to be seen as a dealer, right? Especially like you’re working on multiple properties all at once, or you do it multiple times a year, that’s someone who’s going to be seen as a quote-unquote dealer, right? So like that’s like, I would say those are the two clear ends of the spectrum, right?

But what are the people who like, let’s say a real estate agent who they do sell properties every once in a while, right? But it makes sense, like just like, or like it makes sense. Well, they held it for a year and a half, they held it for two years, right? Now it’s like, okay, well now it feels a little muddier. It’s like, well, I sell real estate as a living, even though I don’t personally own it, but also I’m selling my properties kind of like I would say maybe infrequent basis, maybe not frequent, but like what does that look like? What does that mean? Am I considered a dealer now?

It’s like that’s where we get into that ambiguity of essentially is like what the tax code asks us is like is this what’s quote-unquote called inventory or held primarily for sale or is this going to be a capital asset, right?

Capital Asset

As a tax code defines it, and tax code basically says, hey, everything’s a capital asset unless you’re holding it primarily for sale in a trade or business, right? And that’s actually defined. We love talking about tax court cases on this podcast because you guys will go read them. Surprisingly, I thought was the only one out there, but one of them is called Malat, right? It’s actually a Supreme Court case back in the old 1960s.

So been good case law for a long time, and basically states where the Supreme Court says, hey, code section 1221, right, that is what defines a capital asset. They say it is basically, it’s like you hold this for, of principally or of first importance, right? So like essentially what was your original intent when you purchased this property? That’s kind of like what we have to decipher when we’re looking at these kinds of aspects.

Determination of Investment

Ryan: Yeah, there’s a lot to unpack here and that’s where we’re going to continue to dive into is how do we continue to help you as a listener determine is this a capital investment where when I sell it, it’s at that maximum of say 23.8%, and just a comment, we’re not looking at state income tax, we’re just looking at federal for our discussion today, but also then diving into, okay, what are the factors where the courts have come out and said, hey, these are the factors that made a distinction and made these people either win, kind of continue to hold their position that it was yes, a capital asset versus where maybe they lost and they actually were determined to be considered a dealer and that had massive tax savings kind of like we’ve talked about right at the beginning.

So Nathan, let’s just start to talk about what does kind of start to help us draw distinctions. We know that this is a pretty muddy area as we start to make these distinctions, but let’s just start walking through big picture. What are some of those distinctions to help the listeners think through, I’m a dealer or I’m not?

Dealer Status Winthrop Factors

Nathan: Yeah, so this comes from like, as Ryan’s kind of mentioned at the top of the podcast, there’s a factor test, right? And whenever we have a factor test in tax, we are able to help find, help our clients find value because that means we’ve now landed into a place of ambiguity. The tax code even is like, there’s nothing that’s like, right, it’s like one of the favorite things that like you, if you ever talk to a CPA, they might say you, it depends, and that probably frustrates all investors a whole lot like, well, I want a straight answer.

Well, it’s not always straight, but there are ways we can get to answers, right? And with these kinds of factor tests, tax court uses, and this set of factors are called the Winthrop factors, right? And so they’ve been heavily used in case law for basically since 1969, basically. So very important.

Factor One

But yeah, so number one, the first Winthrop factor that is viewed is the nature and, and also like going back real fast, is that technically none of these factors have like, they all hold equal weight per the tax courts, right? So they should all hold equal weight.

However, the ones that actually like some courts have said that this actually weighs more heavily than other ones, even though they’re supposed to essentially be the same weight, but we’ll talk about that here in a little bit. So factor number one is, and this is one of the heavier ones, is the nature and purpose of the acquisition of the property and the duration of ownership, right?

So if you purchase property, right, and you immediately, let’s say you buy land, and you, let’s say you buy land and you immediately start developing it, subdividing it, putting down roads and improvements, getting it ready for a sale for someone to residential Lodge or something like that, then you’re going to end up being seen as a dealer, right? Like that’s a hundred percent example that’s happened time and time again in tax court, right? So if like you purchase it, immediately start working on it, and then even if like, let’s say you hold it for two years, but then you start working on it, the tax court is going to go back and ask you is like, what was your principal reason for doing this, right?

The Winthrop Standard

So like, why, why did you do this? You know, there’s one of the big court cases was, was in Winthrop, for example, was like basically like they required the property for inheritance, and they never used the land. All of a sudden they started subdividing it and selling the land almost immediately. And so the court is like, you’re not holding this for investment, right? That’s not an investment property. This is a dealer-type property. So you are going to be subject to ordinary income rates here.

Ryan: Yeah, and one thing I’ll just comment on before Nathan continues to go on, the Winthrop factors that we’re talking about is from a court case. That’s where we’re talking about this. This is like a kind of further back, like Nathan said, back in the 60s. So this has become a little bit of a standard for CPAs and taxpayers like you thinking through what things are the IRS going to evaluate. And from there we’ve kind of seen additional court cases to kind of help fill in some of these main topics. So Nathan, if you just want to continue on as far as, you know, the other seven, continue on, man.

Factor Two

Nathan: Yeah, absolutely. So factor two is the nature extent of effort to sell said property, right? So basically like you’re looking at, should this be like, should this be inventory, right? Like, what are you doing here? Like, how are you calling people up and saying, hey, are you interested in buying a property, right? Are you calling brokers saying, hey, are you looking to acquire anything right now that you want to resell? Are you advertising it and listing it? Like how, and sure, like, like as an, like you might be asking yourself, well, as an investor, I listed my property on Zillow or I listed, or like, I got a real estate agent, right? It’s like, you can have those kinds of things, but how aggressive are you, right? Did you go get three brokers, right? Who are both listing your property?

Well, I don’t think you can do that, but like, are you being aggressive in like, how you’re trying to get someone to get your property out of your hands into someone else’s, right? How aggressive are you being with that? There’s no actual like explanation for why this one is important, but like it’s come up a lot in tax, right? So it’s come up a lot. So going back to Winthrop real fast, is like the taxpayer didn’t advertise, right? They didn’t advertise at all, but they were a licensed real estate broker. So they were seen as being the solicitors themselves, right? It’s what they did as a business.

Factor Three

And then factor three, this is probably the most important one of them all. This is by far the most important. This is what the Fifth Circuit Court has definitely emphasized and other courts have also emphasized is the number, frequency, and continuity of sales, right? And so even then, this is like, I keep saying that like, this is important stuff, but there’s never like, I just want to say, there’s never going to be anything that’s like 100% clear. It’s always going to be facts and circumstances based per if you’re the investor or the flipper situation, right? So the number, frequency of sales is super important. But basically, it’s like, how often are you selling houses, right? How often are you doing these things? Are you doing 32 sales a year, or are you doing 200 sales a year?

Are you a large syndication and like you’re doing multiple sales a year? You’re selling 45, 60 lots over 18 years? Are you selling 42 lots in a two-year period, right? Like, how often are you doing this? Like, how many times, how many deals you doing? And if it’s like, you know, one a year, it depends on your circumstances. You could be seen as like, maybe it takes you that long to renovate the property.

In that case, you might be seen as a dealer, but if it takes you one year and then you hold it for two more, right? Like, yeah, I want to see if I get some rental income, but I can’t. So now I’m selling it. Maybe that’s not frequent enough, right? There’s times, and we like, I think we’ll get to this later, but there’s been times where even one sale has like shown that you are a dealer.

Frequent and Substantial

But this is something that the tax court definitely highlights and like, likes to look through, like, for example, going back to one of the successful cases out there (Bryam), the court stated that 22 sales over a three-year period were substantial.

They were not sufficiently frequent or continuous to compel an inference or intent to hold the property for sale rather than investment, right? So even though they were selling the lots over a period of time, they were not like, definitely, I think it’s more, it was more of a like, hey, yeah, you did a lot of sales. However, this wasn’t something that happened continuously on a regular basis that you were looking for it, right? Like a flipper might, like, I want to do five deals a year. I have to do that so I put on the table, right? It’s like, okay, cool, that makes sense, right?

Examples

In Suburban Realty, right? Sale 244 lots over 32 years, right? That’s basically eight sales a year or something around there. That means you’re going to be, basically you’re doing about eight deals a year. There’s a high chance that you’re going to be seen as a dealer just based on these tax court cases, right?

In another case, they had eight sales of properties over a 10-year period. So basically they were doing like almost one a year, but they were still successful because they weren’t seen as frequent, right? They were still not seen as frequent or substantial. And so it’s like, it comes down to that frequency and substantiality standpoint, right? It’s like, substantial is basically more looking at it from a like, yeah, you, this could be a lot of sales, like it could be a lot of sales, but like what’s like, and then like going back to Byram, what’s the frequency? How often are you doing it? How often are you trying to advocate for the sales? Like, is it coming to you or are you going to look for it? So that’s factor three, probably the most important one.

Factor Three Clarification

Ryan: So one comment I just want to make is that someone listening to this might be like, oh, are you saying I can’t have any sales? You know, whenever you have a sale, yes, it comes with an evaluation. Might an IRS agent or a tax court evaluate you as a dealer? Yes, that you need to consider that. But at the end of the day, Nathan and these factors, we’re not saying that you can’t sell a property, right? Yes, it comes with a teeny bit of risk, but there’s a lot of things to consider.

So if you’re a real estate investor and you’re like, hey, I’ve held this property, it hasn’t worked. It’s been a year, right? I have certain clients where it’s, hey, they bought a short-term rental and they held it for a year, a year plus. They didn’t get the revenue they wanted. You know, things didn’t turn out.

They had a much bigger renovation than they expected, whatever it is. And now they’re like, hey, can I sell this? Yeah, nothing from my conversations with them have ever indicated any sort of intent of like, oh, I’m just going to flip and sell, right? So I just want to comment on that and kind of pause as we get through these first three. You need to consider a lot of things. That’s why we’re going through these just to kind of bring it back. But I do just want to highlight, yes, you can sell property. It’s not an automatic red flag just because you sell property. So Nathan, continue on as you go through this.

STR Example

Nathan: Yeah, and to follow up on that, like I’ve had clients who they bought what they thought was a really good short-term rental, and it was a really good short-term rental. And then someone came down the road and was like, I want to live in your short-term rental full-time. Here is $200,000 over asking price. Well, I mean, you’re not going to say no to $200,000 over what you bought it for, right? So it’s a deal of a lifetime. You’re going to take that 10 times out of 10. That doesn’t mean that this property is going to turn you into a dealer, right? So you’re still an investor. You’re just an investor who happened to have one of the best deals, like that you got your appreciation right then and there at that point in time instead of waiting over a long period.

Clarification Purpose

So that’s like, so totally like those kinds of people can be seen as investors, not dealers, right? That’s why it’s muddy. So like, that’s why we try to, we’re going to try and like with a tax professional or yourself, try to find ways to get these factors on your side, right? It’s like you not might win all of them, right? Maybe lose two out of the seven potentially. As long as you can win five or you can win like, there’s even though there’s not a clear line, you win four or five of these factors, that’s a good fact pattern for you in the case of an IRS audit, in the case of any IRS correspondence, right? That’s going to be the goal here.

So that’s why we’re walking through this. So you guys can have the knowledge and be able to look at these yourselves and determine, ask yourself, am I a dealer? Am I an investor? How does that work? There is a lot of bad information out there, right?

RE Agent Example

There are people who tell real estate agents, hey, if you’re just a real estate agent and you claim real estate professional status, then you are going to be seen as a dealer. And that is not the case whatsoever. I will say that and will say that strongly is that if you are a real estate agent and you’re just selling properties that you do not own, then your rental income is not going to be subject to self-employment tax, right?

Like that is something that I’ve heard a lot of times from clients is that like, if you claim REPS, you’re going to now, all your income is going to be subject to self-employment tax. That’s not correct, right? You’re a real estate agent income, your commissions, sure, subject to self-employment tax, but those sales that you are doing personally as an investor, right? So long as like you are not doing it frequently, you are not doing it substantially, right?

Factor Four

Maybe it’s just once every few years, right? And like us, like I want to get out of this market, get into a new one, or got equity built up and I want to put a larger down payment on to get a larger high scaler short-term rental or long-term rental somewhere else. That’s an investor right there in my opinion, right? So factor four, the extent of subdividing, developing, and advertising, right? If you’re subdividing, grading, rezoning, and selling roads, utilities, you’re probably going to be seen as a dealer on that type of property, right? So like if you are doing all that kind of stuff, like it’s going to be hard to prove capital treatment for you here, right? It’s going back to that 23 versus 52%.

And like that’s something we’re going to have to take a look at and see like, hey, like you can make the property more salable for sure. Like you bought, like you purchased property, like you want to renovate the bathrooms or something like that. That’s okay. But like if you are hardcore going to like subdivide, rezone, do a lot of different stuff, there’s a chance that your sales could be subject to the dealer status, right? And that’s happened multiple times in tax court cases.

Factor Five

And then the fifth factor is use of a business office for sale, right? And so like that comes down to is that like, hey, are you a broker, right? Are you a broker? Do you have the licenses to do this? Do you have the permits to do this on a regular basis, right? And if you do, like there’s been times capital gain treatment has been denied and you’ve been subject to the dealer status, right?

And so that’s something else to consider is that like in a case like going back to, if you are a real estate agent and you are flipping land, you’re flipping houses on a pretty consistent basis, you know, where maybe you could be seen as a real estate dealer from that standpoint, right? So like honestly, like factor five, there’s been a lot of cases where people have lost or won and did not use either.

Factor Six

So, and then factor six, the character and degree of control over the representative of selling the property, right? And this one is probably one of the most confusing in my opinion, is that basically is that like, you can conduct your business through an agent. That won’t alter the fact that you’re engaged in a business. However, if that agent can be used, whether or not, like what your activities are, right? And so this one is like really hard to figure out and figure out like, are you using, like going back to, I was mentioning before, are you using brokers?

Brokers

Are you using brokers for certain sales, right?  Are you using Brokers for some of your investment sales, right? And like, this is where that delineation can be important. It’s like, hey, yeah, some of these are my flipping. Some of these are not my flipping, right? Some of these are, I’m just holding for a long-term, long-term appreciation, rental income. I want to get that appreciation over a long period of time. So I’m going to use, this guy is good at getting deals done quick, right? This guy is really good at getting me the best deal. And I want the best deal on this property because I’ve hold it for a long time, right?

Right. I’m not just looking for the quick gain so I can then get working on the next renovation or something like that. So that’s just something to consider there as well. And like actually brings me to a point is that like, hey, like those of you who have, who are holding, like maybe you got a single LLC and you’ve got your flipping, you’ve got your flips in one, you got your investments in another property, right? You’re holding within the same entity, separate those, right? Let’s get those separated because now you’re leaving yourself to the IRS to make that determination for you.

Entities

And that’s, I would never, I don’t want the IRS ever determining anything for me. So imagine you don’t want the same happening for you. This is an area where I recommend, hey, maybe you should have two different entities and have one, hey, my flipping income is going to sit over here. Maybe that makes sense for you to be an S-Corp. Maybe it doesn’t. That’s something else you should consider. But having a single member LLC that is not an S-Corporation or a partnership, whatever your structure is, that holds your investments and then holds your flips, right? So that way, if you, maybe you are a dealer, because this is the key here, right?

And this is something, something that maybe we haven’t touched on quite a bit is that you can have investment property and you can flipping properties, right? So if you are a flipper, you are not going to 100% be considered to be a flipper. Some of your sales can be investment sales, right? Some of your sales will be flipping sales, right? It just depends on your intent. And that’s why we’re going through these factors. So you can help yourself figure out what’s going to be what, right? So that way you can kind of decipher and see how important some of these things are going to be.

Deciphering Factors

Ryan: Yeah. So Nathan brought up some good points. I just want to bring home to us. So number one, you can be a flipper that also owns real estate investments, right? You can kind of simultaneously be both. It’s not that, hey, I’ve got this dealer status and automatically any sale you have is always going to be considered a flip. So we want to kind of make sure people are hearing that because you might say, hey, I’ve got dealer status. That kind of sounds like real estate professional status, right? It’s basically what I’ve been deemed with, like kind of for a specific year or years to come or something like that. You can have both. These factors that we’re talking about is going to simultaneously evaluate kind of the actual property itself, right?

Your Intent

That’s what we’re talking about. But also as well, like who are you as far as like a business owner, right? So there is like a broader picture look, but then there is also a look at specifically what about this property, right? What was your intent in buying this property? And then the other thing I was just going to bring home to, you will hear from, you know, all these factors from Winthrop, nothing has anything to do with entity structuring, okay? So I just want people to also know though that having the separation could potentially provide additional clarity to the IRS.

Hey, look, whenever I put a property into this LLC, this, the intent is for flipping. Whenever I put a property into this, call it a holding company, I always am expecting, and the intent here is for rental properties, right? So it’s not a specific factor that we’re going to call out as far as like, oh, they looked at entity structuring as far as I’m aware, Nathan, and you can correct me. But at the end of the day, it’s just another piece of how you can structure things on the front end to potentially help you win as far as separating which things are flips and which things are rental properties. So just wanted to chime in there on those things. But yeah, feel free to hit us with number seven for the Winthrop factors.

Final Factor

Nathan: Yeah, here’s our last and final Winthrop factor, and thank you for that, is time and effort the taxpayer devoted to sales, right? Like I said, is that if you’re putting a lot of effort into this, you’re putting a lot of time, a lot of effort devoted to these sales, you’re trying hard to get them done personally, right? You’re not soliciting other agents to come and take care of the property. You yourself are going out and you’re trying to get these things sold. It’s probably going to be seen as inventory, right? Like you’re probably going to be seen as a dealer from that standpoint.

If you’re trying hard to get this property, and I understand like sometimes we have investment properties for a long time, and then like we do try hard because like, hey, look, I need to get rid of this property. It’s bleeding cash for me right now. I need to get out from under it. That’s not necessarily going to mean that like you’re going to be a dealer, right? It’s that like once again, like these factors, like Ryan was just saying, that like just hitting one of these factors does not mean you are trapped forever with dealer status, right? Just because on one property you were a dealer does not mean the next property you’re going to be a dealer.

Now, if you continue on with that, you might be viewed as a dealer, but just because like Ryan’s saying, you can have the investment and you can have dealer properties, right? But again, if you are doing a lot of this advocation for yourself, there’s a good chance that you could be seen as a dealer, right?

Documentation and Best Practices

Ryan: As we’ve kind of now gone through the seven factors again from Winthrop, a very old case and Winthrop lost as far as I’m aware, Nathan, just correct me. I think that was true that he lost and he was nailed with the dealer status, which was unfortunate. But as people who are listening right now, right?

At the end of the day, it comes down to these factors, but supporting that with documentation, right? If anything ever goes to an IRS agent, IRS agent is going to say, hey, nope, here’s the condemnation to you or here’s the thing that we think is true. If you’re going to argue that, right, eventually you’re going to get to a tax court case. And that’s why we’re going through things like Winthrop. They all ended up there, right? But what things can listeners be doing if they’re kind of in this muddy waters? What documentation might they need, and what can be helpful or what might be kind of a detriment to them in supporting not being that dealer status? What can we do?

Nathan: Yeah. So one example, honestly, is the classification on your tax return. If you file a partnership tax return, if you look on, hopefully you all look at your tax returns and review your tax returns, but so there’s a schedule L, it’s going to be page five of 1065, I believe, at least it was last time I checked. So there’s an investment bucket, right? So there’s an inventory bucket and there’s an investment bucket. And if this is truly an investment property and you want this to be an investment property, the tax courts will go back and look at your prior tax returns and see how did you previously classify this.

Musselwhite Introduction

There’s a court case we’ll talk a little bit more in a little bit called Musselwhite, where a real estate attorney had some land. He had it in investment bucket for a long period of time on his tax return on his, on his investment tax return, his partnership. And then later on in the years, he flipped it to in inventory, right? So now he wanted to get ordinary loss. And then the tax court decided he was going to get capital loss because they looked back at that treatment, right? So doing those kinds of things, showing your intention, maybe writing a documentation what you are wanting to do on said date, right? And have that documented, have the metadata of the Word document actually match the date that you created it, right?

Showing your Intention

So like the tax courts have looked at that and seen like, hey, did you just make this right before you walked in here? Or did you actually create it on the date that you said you would, right? So something to think about there is having that kind of documentation, having a plan, right? If you have a plan of like, hey, we want to hold this property for probably four to five years. We’re going to see what the appreciation is at that point in time. And then we’ll think about like make a decision, right? Right. Like we think this is a good area. Maybe we can get some good lease. Maybe we can lease this to some people in the time, get some good cash flow while we let the property appreciate.

And so almost no one holds a property for life, right? I don’t think I know I’ve ever seen a real estate dealer and besides some, maybe some of the older folk that we, that we talk with who have held these properties for forever and ever and ever. Most of the time you’re going to make it sell at some point in time, which like we’ve said multiple times, that is okay. So having plans, having written documentation of said plans, and just like having classifications on tax returns, those can be good fact patterns for us and help lend towards the investor treatment instead of the dealer treatment.

Musselwhite Discussion

Ryan: Yeah, that’s really good. So to summarize that, prior year tax returns, right? We can talk about Musselwhite here in a second. I just want one more comment on that, but also maybe like a document kind of talking about your intent, right? What’s my plan here? What am I going to do? Maybe that’s an email to a business partner or just for yourself, just kind of outlining what that is. But those are two things to be considering. And just to comment too on something Nathan said, so the treatment originally for Musselwhite was that they had it as an investment, okay? Which means initially we’re starting to think, okay, this is going to be capital, right? Capital property.

Then they switched it to an inventory, which now would start to indicate, oh, now that’s becoming under that dealer status. And when we sell it, it’s going to get to that 52 point whatever percent, right? And so the unique thing for Musselwhite that just want to help people understand is that he actually had a loss, okay? Sounds like a really substantial loss, like a million bucks or something, right Nathan? So a million dollars of loss. So what is more beneficial for him? It is more beneficial actually that he claims effectively that dealer status because now that million dollars of loss can now be considered ordinary and actually offset things like his real estate attorney income, right? So that was more beneficial.

The Move

So what did he do last minute or the last year?

He moves it to inventory. Well, the court looks back and says, hey, your intent was that it was capital. So now the court comes back and says, hey, we see what your intent was. We’re changing that back to be capital. And so now because that’s a capital loss, we all know that capital losses can only be at a maximum taken in a year up to $3,000 of losses. So it’s actually detrimental to him in order for that to be switched, which makes sense why he would actually want that to be ordinary. So just want to kind of draw that out as far as like you’ve got effectively the IRS looking at these things to say, hey, you’ve got a gain.

We know that it’s more beneficial for you to have that as capital or you’ve got a loss. We know that it’s more beneficial for you to have that as ordinary, right? So they’re thinking about both sides, whether it’s an income and loss. But Nathan, kind of with that, like where are we at today as far as what you and I were talking about before the episode is kind of this whipsaw treatment. Kind of talk to us about what’s going on there and what’s going on more recently in these core cases.

Recent Developments

Court Cases Explained

Nathan: Yeah, fantastic breakdown of Musselwhite on, there’s literally nothing for me to comment on that. But so more recent year, so Musselwhite was a 2022 case. And so right now, honestly, in the past, I would say 10 years, past decade, the IRS has combed anyone who has, like Ryan was just saying, like you want capital gain in a property, right? Well, they’re going to say it’s actually ordinary income. They’re going to try and classify you as a dealer. And in Musselwhite’s example where you have a substantial loss on a property, right? He purchased his property right before the housing crisis in 2008.

And so therefore what he paid for it in 2006 was no longer worth the value later on years when he wanted to get rid of it, right? When he wanted to sell it. So then he tried to play the game. Well, I won an ordinary loss on this property. I have millions of dollars in attorney income. I’m a partner of a firm. I want this offset. So why not just take, sell this property, get what I get, right? I don’t care what it goes for. I just want tax loss at this point in time. It would be more beneficial for me to get a tax loss. Well, the IRS goes, hold on there. That’s beneficial for you. That’s not beneficial for us. So we’re going to flip that treatment.

And so what’s been happening in the past decade is this whipsaw treatment of like, hey, you want to get capital gain treatment or you want to get ordinary loss treatment? Well, the IRS is going to combat you on whichever side you don’t want to be on. And honestly, more frequently, they’ve won more than they’ve lost.

Documentation Needed

So in Allen, for example, right, we talked a lot about the frequent and continuous sales factor, right? That’s like, if you’ve never made a sale before, and like, I’m not saying this to alarm people, but I just want to like bring it up. Like this needs to be discussed because this is a 2014 tax case. So Allen, for example, he was a civil engineer. He worked for a land developer and he actually purchased some land himself. And then he actually ended up being a bad deal and he wanted to get out from underneath it. And so he sold it, right? He sold it for a gain. He classified it as capital. IRS came and said, no, that’s ordinary. We think you’re a dealer.

Sales History

And he said, I’ve never had sales before. This is the most important factor. I’ve never sold anything before. Never sold real estate before. That’s the only time I’ve ever sold real estate. I think I hate selling real estate because it went so poorly for me. I did not like it. The court found that that didn’t matter. That previous substantial sales didn’t matter whatsoever.

And so he is like, there’s not a quote-unquote one bite rule. Like basically, like once you’ve done it once, now you’re tainted forever. Basically, it’s like, hey, yeah, nope. We think that in this scenario, even though you’ve never done sales before, that you were seen as a real estate dealer and he had ordinary income, right? And on the flip side, there’s another tax court case called Evans, right? Where Evans is like in a similar year where he won an ordinary loss, right? He had bad deals on some properties, went for sale, foreclosure. And he had done flips before, right? He couldn’t really, he said he’d done eight or nine. He unfortunately didn’t have records.

Facts Necessary

So there’s another fact pattern, like we, Ryan was saying before, have records, have documentation of these things and you’ll be able to do, like you’ll be able to prove more out. You have more facts on your side, but he was not able to prove out that he was a dealer.

And this investment was one of his dealer properties, even though he had done this before. The IRS said, no, this was an investment property for you. Therefore, the loss you’re going to get is going to be limited to $3,000. And the tax court ended up again against him on the IRS’s side. So right now there’s a lot of whipsawing going on in tax court, right? And so whether or not we’re going to see some of these types of cases go up to higher courts, right? Like the Fifth Circuit, the Sixth Circuit, right? Those upper appellate courts, those district courts, we’ll have to wait and see on how these get decided.

As of right now, I don’t know of any that are being debated, but we’ll have to wait and see if these get overturned or if they are the current law. Because right now, current law, it looks like you could get into some really bad treatment. You get stuck, not with bad treatment, with dealer treatment in a scenario where the IRS is able to fight against you, right?

Evaluation & Care

Ryan: Yeah, you’ve got to be careful out there if you’re going to have even just one sale, right? I think that goes to the Allen case where it’s just literally the first sale or one sale. So it’s not like, oh, I’ve never done this before, therefore it’s, I’m in the clear. Or like some people might be listening and saying like, oh, my first one, I’ll be clear, you know, to get away with the capital gain treatment. It’s really going to come down to more than that. And so people need to be evaluating and be careful. You actually might have an idea of what’s going on here, but if you don’t have support documentation, the facts, the circumstances don’t align, there just know that it’s going to cause some suspicion and you’re going to need to have support for yourself to do that.

And it seems like right now, you know, Nathan, you and I were talking beforehand, it’s like the goal of the IRS is for you to lose, which makes sense, right? They’re there to basically enforce the law and to try to earn more revenue in the form of taxes by going after people they think are good targets. So as we kind of wrap up today, I think this has been a fantastic episode. We haven’t touched on this in quite a while, but if you were to just kind of give a final comment to people listening, hey, I’ve got a sale of a property coming up or I’m thinking about doing flipping or whatever, what would be like, hey, if I could say one thing to these listeners to kind of summarize all of this, what would be like your comment recommendation to them?

Final Recommendations

Importance of a Plan

Nathan: Yeah. So I would say is like, it depends, right? No, I’m kidding. Essentially, you’re going to need to have a plan. You’re going to need to have some kind of documentation of your intent, right? When you purchase this property, the reason why you want to have it. And if later down the road, your mind changes, right? You want to hold it for appreciation, but now you’re selling it. Why, why are you selling it? What are the reasons behind you’re doing this? Why did it change from what you said it originally was? If you can back that up, it’s going to be a good fact pattern for you, right? And if you can have delineation between what is investment and what isn’t investment, right? That’s also going to be helpful for us because then we’re going to be able to have documentation.

Audit Proof

And let’s say IRS audit ever did appear or you did go before tax court, you can show them visibly and physically the reasons why you did what you did. That’s what’s so key here. That’s what’s so key here is that like you have this and you know what, like maybe you are going to be stuck with dealer status. If you are, then you should probably consult with an advisor and see maybe if an S corporation for your sales is worthwhile, right? Like there’s a lot of savings that we, we have a lot of, we have a lot of clients who are involved in flipping and seeing who take great tax benefits from being an S corporation.

Now that doesn’t always work for everybody and maybe it doesn’t work for your first year. Maybe it is your first few sales. And again, there’s a lot of opportunity here. It’s just going to be whether or not you can prove out why you’re doing what you’re doing and you can show your intent and whether or not you can have these fact patterns on your side.

Importance of Documentation for Dealer Status

Ryan: Yep. And just one other comment I’ll add in, you can’t just simply take your tax return and put everything that is really inventory into investments or anything like that. You can’t simply just have all of your documents for every purchase say, Hey, my intent is to hold this and be a capital asset. Like that’s not going to work. But what we’re trying to just instill is that that documentation is going to help support if the other facts and circumstances point to that. You can’t just make stuff up, right?

The IRS is going to sniff those things out and they’re going to bring that to light and say, Hey, this doesn’t make sense. This doesn’t align with what you actually did because you actually turned around and subdivided this and blah, blah, blah. And so everything needs to align, right? But this additional support, this documentation is going to give you that additional help to really show intent and things like that. So I just wanted to comment on that as we kind of wrap up today’s episode.