Tag: co-owners

Investor vs. Dealer

Purchasing real estate assets? This post explains what you need to know about the important distinction between real estate investor and dealer for tax purposes.

A real estate developer is taxed differently than a real estate investor. Real estate investors purchase real estate with the intention of holding properties and gaining financial return. Typically, real estate dealers acquire and sell real estate as part of their everyday business.

career or new opportunity concept, business backgroundA real estate professional who is involved in buying real estate with the intention of selling for a profit in a short time frame, or flipping is usually considered a dealer. Contractors and builders who build houses and commercial structures, and subsequently sell the finished property to customers are also considered dealers.

A question that arises often is whether a real estate developer who purchases properties (sometimes raw land or an outdated property) and makes improvements should be considered an investor or a dealer. Real estate developers are usually treated as dealers by the IRS because they are in the business of buying and selling real estate. However, if the developers work on individual and sporadic long-term projects, they may be able to take a position they should be taxed as investors.

Why does it matter to real estate professionals?

When a real estate investor sells property that has been owned for more than one year, gain on the sale is taxed at the favorable long term capital gains rates, currently 15% or 20% depending upon income (plus the 3.8% net investment income tax, if applicable).

When real estate dealers sell their properties, those properties are considered inventory and any gains are taxed at the dealers’ ordinary income tax rates. Currently, Federal ordinary income tax rates can be as high as 39.6%.

The Internal Revenue Code offers general guidelines regarding activities that reach the level of a trade or business. However, Internal Code does not provide specific guidance regarding real estate activities. Consequently, court cases have been the primary source for defining what level of activity determines a trade or business in real estate development and, therefore, the nature of the income.

The main factor in determining if a taxpayer is a real estate investor or a dealer is his or her intent with respect to the property. The mere fact that an individual holds a piece of property for a short period of time does not automatically cause him or her to be a dealer. Often an individual purchases real estate with the intent of holding it for investment purposes, but sells it earlier due for financial or economic reasons.

Consider the Winthrop Factors

A case often cited when determining dealer vs. investor status is United States v. Winthrop. In determining whether the gain from sales was ordinary or capital in nature the court relied on a series of facts and circumstances in the Winthrop case. These have become commonly referred to as the “Winthrop Factors.”

Subsequent court cases have enumerated the following 9 Winthrop Factors:

  1. The purpose for which the property was initially acquired
  2. The purpose for which the property was subsequently held
  3. The extent of improvements made to the property
  4. The number and frequency of sales over time
  5. The extent to which the property has been disposed of
  6. The nature of the taxpayer’s business, including other activities and assets
  7. The amount of advertising/promotion, either directly or through a third party
  8. The listing of the property for sale through a broker
  9. The purpose of the held property at time of sale; the classification as an investor or dealer is determined on a property-by-property basis.

Talk to your tax professional

With such a wide disparity between the maximum capital gains tax rate of 20% (plus the net investment income tax 3.8%) and the tax rate on ordinary income of 39.6%, it is important to consult your tax advisor regarding newly acquired real estate assets and established investments.

Buy-Sell Agreements

 

Buy-sell agreements are the most important, but perhaps most overlooked agreement that a business can have. These legal documents protect business owners when one owner leaves the company for any reason.

Although many businesses have buy-sell agreements, they were likely drafted when the business was formed many years ago and have not been looked at or updated since. If your business has a buy-sell agreement, take it out, read it, and ask your accountant to calculate what would happen if the agreement were triggered today. Evaluate the results from both sides, as a buyer and as a seller.

  1. The first question is, is the price calculated pursuant to the agreement fair to all parties? If is unfair, it is time to execute a new agreement. (By the way, don’t assume that the younger party to the agreement will be the buyer, or that the older party will be the seller. Owners may leave their businesses for many reasons.)
  2. Another important issue in buy-sell agreements is the payment terms. Does the agreement require a lump sum payment or payments over an extended period of time? If a lump sum payment is required, how will that payment be funded? If funded by insurance, is the policy still in force and is the amount sufficient to make the payment? That $1 million term policy that was purchased when the business was formed may not be enough to cover the price today if the business has grown. Also, term insurance expires at certain ages, perhaps leaving no funding for the agreement.
  3. If the agreement requires that the business be valued, it should specify the standard of value to be used. There are big differences between fair market value and fair value. I once served as an expert in a dispute in which the agreement used the term “value.” The standard of value issue was eventually resolved, but not before the parties spent a lot on legal fees.

Don’t pay the price for no agreement

Not having a buy-sell agreement is a different kind of agreement—one to spend a lot of money, perhaps hundreds of thousands of dollars, on professional fees, and years to resolve the issues. Companies without an agreement end up letting a judge or a jury decide what will happen to the business that they worked so hard to build.

Although it is often an uncomfortable conversation to have with your partner, it is a much easier conversation to have now, when you are both healthy, your interests are aligned, and retirement or disability is not on the horizon. It is a far more difficult to reach an agreement after a triggering event, especially when that conversation is with a widow or children who are not at all concerned with fairness.

I have only touched on a few of the issues surrounding buy-sell agreements.

Take a look at your agreement with your CPA and attorney to be sure that it is up-to-date, or contact me at [email protected] with comments and questions.

Advantages of the Tenant in Common Arrangement

Tenant-in-common ownership, sometimes called tenancy-in-common, is a method of holding title to property involving multiple owners. When a tenancy-in-common arrangement is created, each individual owner, called a “co-tenant” or “co-owner,” owns an undivided interest in the property.

Typical Tenant-in-Common Interest

tenant in common investment
Typical tenant-in-common agreements involve many individuals who each own a fractional interest in a property.

A typical tenant-in-common (“TIC”) interest involves a number of parties, generally unknown to each other, who each own an undivided tenancy-in-common interest in real property.

There can be any number of co-owners. Ownership of a TIC allows the investor to own a fractional interest in a property that is typically investment-grade and professionally managed.

Why Tenant-in-Common?

One advantage of TIC investment is the potential for tax-free exchange treatment. In 2002, the IRS issued Revenue Procedure 2002-22, which states that a taxpayer can use a TIC investment, if properly structured, as either relinquished property or replacement property in a qualifying like-kind exchange.
(I covered like-kind exchanges in my previous post, “Understanding IRC Code Section 1031 and Why You Should Care.”)

The relationship among TIC owners is generally controlled by a tenancy-in-common agreement (“TIC Agreement”). Decisions to sell, borrow, or lease a property, or hire property management, are typically controlled by the TIC Agreement.

Additional Advantages

There are other benefits to TIC ownership, including professional property management, diversification, appreciation, and predictable cash flow.  Investors may counter that they can receive these benefits in a partnership structure; however, a partnership interest is considered personal property and cannot be exchanged. (The Internal Revenue Code specifically prohibits the exchange of partnership interests.) However, an LLC or partnership can do a 1031 exchange on the entity level.  This means the partnership relinquishes the property and the partnership purchases a replacement property.

If you are buying a property with another person or persons, KRS CPAs can help you set up a tenancy in common. Give us a call at 201-655-7411 or email [email protected].