Investors in real estate generally do so for financial gain. The upside to investing in real estate is that investors get a return on their investment and receive cash distributions but are also able to defer income tax. The significant depreciation that the property provides offsets the rental income and often times generates losses. These losses that are passed through to investors are not usually deductible in the year incurred (unless the taxpayer is a real estate professional) because taxpayers that invest in real estate are generally considered passive investors. Passive investors are only able to offset passive losses against income from passive activities. In the case where a taxpayer may invest in multiple real estate transactions they may incur a net loss on one investment and a net gain on another. This passive income and loss would offset one another. Otherwise, passive losses are carried forward until they can be offset by passive income or until the property is disposed. In the case of disposal, any prior disallowed losses would be released and offset ordinary income. If the property is held for longer than a year the gain is taxed at the capital gains rate of 20% and any depreciation recaptured would be taxed at a rate of 25%. Both rates still favorable to the maximum ordinary rate of 39.6%. In addition, pass through income from real estate investments are generally subject to the net investment income tax of 3.8%.
Dealers in real estate have different tax implications than investors and do not benefit from the characteristics discussed above. When you are a dealer in real estate you are considered to be active and materially participating in the trade or business. The real estate is not depreciable and so the significant offset to the income is lost. A dealer in real estate treats the property as inventory. The sale is considered to be done in the ordinary course of business. As such, any gain or loss incurred is taxed in the current year at ordinary rates. Losses that are incurred as a dealer are deductible in that year and are able to offset other income. Unlike investors in real estate, the dealer’s income is not subject to the net investment income tax of 3.8%.
Factors to consider when determining whether property is held for investment or for sale in a trade or business include:
- The nature of the acquisition of the property
- The frequency and continuity of sales over an extended period
- The nature and the extent of the taxpayer’s business
- The activity of the seller about the property
- The extent and substantiality of the transactions
For more information about these factors and how investing or dealing in real estate impacts your tax position contact a member of our Real Estate team.