Not all real estate investors are created equal in the eyes of the IRS, which means not all tax planning will work for everyone. The IRS classifies real estate investors into four separate categories. What works for real estate investors won't work for dealers or developers and may or may not work for professionals. You need to know where you fit to maximize your tax savings and minimize tax issues. You may even find that you fit in more than one place!

Real Estate Investor. A real estate investor is someone who passively invests in real estate for long-term periods (one year or more). Any type of real estate counts here, from single family homes to industrial parks to bare land to anything in between. You can own properties that you are doing rent-to-own programs with, and have a sitting tenant and ongoing purchase option. You can own a trailer park, or even a campground and still be a real estate investor, although you'd need a bit of extra structuring for these last two options.

Real Estate Dealer. Any time you purchase real estate with the intent of selling it for more than you paid you are in the business of real estate. At seminars I tell people that: "flipping burgers or flipping houses - it's all the same to the IRS." If you buy and sell properties fairly quickly; if you work the foreclosure market; if you look for undervalued, under-maintained properties to renovate and resell, you aren't a real estate investor - you are a real estate business owner.

For tax purposes your income is considered active, earned income. The typical passive real estate investor holding structures like an LLC (limited liability company) with pass-through taxation won't work for you here. In fact using a passive holding structure here can increase your tax bill unnecessarily.

Real Estate Developer. A real estate developer is someone who develops property, typically from bare land (although if you buy and rehab properties there are times when you could also be considered a real estate developer). The key to determining whether you are a developer is whether you must perform work to put the property into service. The development might be subdivision, land improvement or even rehabbing a property. You would be treated as a developer during the time that you held the property before it was put in service.

The tax issues come when you have inventory left over at the end of a year, which is typical for most developers. Now you'll have to participate in something called Uniform Capitalization (U Cap). This is a complicated part of tax law that requires you to capitalize costs associated with the property. You can't take a current deduction for these costs, so, your mortgage interest and property tax won't be deductible right away. You'll need to have deep pockets to keep your development moving forward.

Real Estate Professional

A real estate professional is someone who:

  • Owns 5% or more of a real estate business, OR
  • Spends a minimum of 750 hours per year working exclusively on real estate activities, OR
  • Spends more time on real estate activities than anything else and still meets the 750 hours per year rule.

If you are a real estate agent, you're most likely paid as an independent contractor. That independent contractor income is your business, and so you qualify. However, if you are paid as an employee of a real estate agency and do not own a minimum of 5 percent of the company, then you won't qualify under this provision.

If you can qualify as a real estate professional you now have the ability to offset 100% of your real estate losses (which can be significant on paper). If you can't qualify as a real estate professional your losses are limited to $25,000, and that's only if your income is under $100,000. The $25,000 starts phasing out after that and disappears entirely once your income hits $150,000. But, if you're subject to alternative minimum tax then this strategy won't work in either case, because you can't write off these losses against AMT.

Because the IRS looks at the individual properties rather than just you as a whole, it's also possible to be treated differently for different properties or deals. Good tax planning, such as grouping activities within different business structures can help you maximize your tax savings here. But you've got to know what the differences are before you can put the strategies to best use.

Stay tuned to the TaxLoopholes Blog for the latest tax information!

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