How To Avoid “Dealer” Status When Wholesaling Houses
It PAY$ To Be A Real Estate Wholesaler!!!
Recently I was asked by one of my mentoring students what the "dealer status" meant and how did that affect them trying to be a real estate wholesaler. While I am not a tax attorney or CPA, or trying to give any legal advice I wanted to help them understand the basic implications of being classified as a dealer so they could sit down with their CPA and come up with a game plan. I think there are many new investors that get caught in this "tax trap" that can actually be easily avoided with a little entity and business planning... and that is why I am writing this blog post for you!!! ;-)
First, let's review what is wholesaling. Wholesaling real estate is simply placing a property under contract at a significant discount and immediately reselling, or assigning your contractual rights to another end user or investor at a discount. The difference between significant discount and discount is your profit as the wholesaler. A typical wholesale transaction happens within a 30 day period, but some last a little longer. I have never seen one take longer than 12 months.
The reason I bring up the months is that when an investor sells a property within 12 months they are subject to short term capital gains which is taxed in your individual tax brackets. This would be true if not for the "dealer" classification. Treasury Regulations Section 1.402(a)-4 defines a dealer as "a person who is engaged in the business of selling real estate to customers with a view to the gains and profits that may be derived from such sales." In other words they look at you like any other business that sells widgets and tax you a 15.3% self employment tax that is added onto your personal tax bracket. Here are some other downsides to being classified as a dealer:
- If you hold rental properties in the same entity that you wholesale through you WILL lose the ability to take depreciation (because they will view your rentals as inventory)!
- You cannot 1031 Exchange your profits into another investment.
- Probably the worst downside is the fact that you cannot "defer income" if you use creative seller financing to sell the property over time (which is a huge tax benefit to an installment sale). You would have to take the entire tax hit immediately.
The crappy thing is there is no set of transactions that has to be met in order to classify you as a dealer. In fact there are no real guidelines as to when you are or are not a dealer at all... instead the IRS conducts an "Intent Based Test" which looks at things like history, purpose, frequency, time & effort, extent of involvement, profit, etc.
SO WHAT IS THE SOLUTION TO AVOID “DEALER” STATUS?
So being classified as a real estate dealer SUCKS but there is hope. If you plan on owning rentals then definitely keep them away from the entity that you wholesale thru. If you plan on making wholesaling a profession then try setting up an LLC and elect it to be treated as an S-Corp. The reason is just an LLC alone is not good enough. An LLC is a pass-through entity and since an LLC is disregarded for tax purposes the dealer status will flow right though to you. But an LLC treated as an S-Corp or setting up a C-Corp will do the trick because it is not a pass through entity and you personally will not incur a self employment tax along with all the other downsides of being a dealer.
IF YOU ARE WHOLESALING TALK WITH YOUR CPA OR TAX ATTORNEY AND PLAN AROUND THE DEALER STATUS AT ALL COST! I use an LLC treated as an S-Corp and because of the amount of transactions I do (100+ per year) it works great for me but your situation may be different. So rely on your power team members to help you design your business in a way that not only helps you maximize profits, but minimize taxes which is just as important!
Hope this gets you thinking about making and saving money...now go take action and start generating income wholesaling real estate. Now is the best time in our lifetimes to generate true wealth by investing and flipping real estate.
To Your Continued Success,
Cody Sperber a.k.a Clever Investor