Hi, everyone. This is the How to Lower Your Tax
Bill podcast. I'm your host, Terrence Hutchins.
I'm a financial and tax advisor in the Dallas
Fort Worth area. And the goal of this podcast
is to help you listeners get educated on different
tax strategies that you can implement to improve
your tax situation immediately. Each episode
will break down useful tax tips you can use to
save money, no matter what your personal or business
income situation. because our motto is, keep
more of what you earn. So let's get into today's
episode. All right, so thanks for joining in
on another episode of How to Law Your Tax Bill.
We've been going over a series relating to real
estate and we've probably been looking at it
through the lens of someone who's a W -2 employee.
we're gonna pin it a little bit and talk about
more from the perspective of someone who's actually
looking to go full -time in real estate. The
things we're gonna talk about will impact someone
who invests here and there, but they will be
more applicable to someone who's actually gonna
do it full -time or has it as their full -time
job. In this episode, we're gonna break down
what it actually means to be a dealer versus
an investor, how the IRS decides whether you're
a dealer or an investor. what the tax impact
of that classification is, and then some strategies
to help you protect your profits. So if you're
a house flipper or you're looking to buy a rental,
so you wanna do a little bit of both, this is
gonna be a good episode for you. Now, one of
the more important aspects of getting into real
estate or any other investment is assessing what
you're trying to accomplish. If I wanna quit
my job, for example, and I wanna live off my
real estate as soon as possible, then that's
gonna take me down a different road than if I
was someone who just wanted to build some additional
long -term income that's gonna supplement my
other investments. Having an idea of what you're
looking to accomplish at the beginning, as Stephen
Covey says, begin with the end in mind. And so
if I know what I'm trying to accomplish, that's
gonna help dictate the type of deals that I do
and whether a deal is good for me or not. But
in order to make it objective, whether I'm in
real estate or any other investment, I think
it's also important to have some kind of criteria
that helps you filter out the investment that
you're underwriting to determine if it's something
you should invest in or maybe it's something
that you should wait on. And so I personally
have a seven part component that will help me
filter out investments that I look at or even
help clients in that component to where they
can simplify what is the aspects of this investment
I'm looking at and then how is that applicable
to me and how I'm assessing whether it's worth
it or not. So those seven criteria are, number
one, risk. What is the chance that I could lose
my money in this deal? If there's more risk involved,
then I am gonna want, number two, more upside.
The upside is just the possible potential. The
ability to make 20 % is gonna look different
than something that makes 10%, but the risk involved
and all the other factors could impact whether
I would go with something that's just gonna give
me 10 versus something that's gonna give me 20.
That's normally how cap rates work. on the commercial
side, where a low risk investment is gonna have
a low cap rate, the higher risk investment is
gonna have a higher cap rate just because you're
gonna wanna have more upside potential. You also
have the tax treatment, which we'll get into
specifically with real estate dealers versus
investors. But what are the tax impacts of what
you're doing is gonna play a big role in what
you decide to do as far as your investments.
Also control, many people like real estate because
they feel like they have more control over the
outcomes. and there are certain things you can
do to help drive up your returns whether that's
with financing or expertise. You also have effort.
Real estate and other investments can look more
like a traditional job. You want to measure is
your time better spent investing in this activity
or just doing work in maybe the career you have
or in your business because you would end up
with more money just putting more effort into
that activity. There's also an element of time.
How long is it going to take you to get your
money back? If it takes me a year to get my money
back, that's going to look a lot different than
it's going to take five years. So I need to be
compensated for the longer it takes me to get
my money back. And then you also have fees. Now,
fees could be a polarizing topic, but normally
you want the fees to be worth whatever you're
putting your money in. So it's not a matter of
higher fee is worse. It's more about what am
I getting for that higher fee and is going to
provide me with more value. So if you look at
your investment options through these seven things,
I think it'll help you become a better investor
and to be more objective. So let's get into the
crux of this episode as we're talking about whether
you want to be a real estate investor or whether
I should say you would be classified as a real
estate dealer or as an investor. So the short
of it is a real estate investor is someone who
buys property to hold it. Maybe it's a rental
or maybe it's land for long -term appreciation.
You normally will buy this and think that, all
right, This is more your traditional person.
I want to go buy an investment property, I'll
get a renter for it, and I'm going to hold it.
If I get an opportunity to sell it at a good
price, I will, but that's not normally the intent
of when you first buy it. Rather, if you're a
dealer, that is actually your intent. You're
looking to buy something in order to profit from
selling it at a higher price, normally in a shorter
period of time. So think of this as someone who
is like a car dealership. They buy cars to immediately
sell them and they're trying to make a spread
on what they originally bought it for and what
they're able to sell it for, but they're not
using time on their side to think that it's just
gonna go up in value by its own. So a dealer
is thinking someone who owns real estate almost
has said it's inventory. Now that's important
because that will determine whether you can pay
capital gains or ordinary tax rates. It's whether
you will also pay self -employment. and whether
you could use certain strategies like a 1031
exchange, which we've talked about in a previous
episode. Now, to be clear, being a real estate
investor does not necessarily mean you're a real
estate professional. The real estate professional
is a separate tax term, which we've gone into
previously, that's tied to rental property rules.
So that's generally tied to your ability to deduct
passive losses and also to avoid the net investment
income tax of 3 .8%. Now, Of course, because
of the IRS and our system is complex at times,
or multifaceted, I should say. Then you could
be an investor, you could be a dealer, and you
could be a real estate professional all at the
same time. It just depends on the facts and circumstances
of your situation. So if you talk to any tax
professional, that word or that phrase, facts
and circumstances, will be prevalent in how they
evaluate your situation because so many things
depend on one of the specifics of your situation.
When looking at the tax treatment behind whether
you're a dealer or an investor, this is really
the 15 or 20 % question that you have to ask
yourself. So number one, if you're considered
a real estate investor, so you're someone who
buys and is looking to hold the property that
you have, when you sell, you're gonna pay capital
gains tax rates. Now, if you sell under a year,
you're gonna pay ordinary income regardless.
But generally, if you hold that property for
a year and a day or more, then you're going to
pay capital gains tax on the sale. And that capital
gains tax peaks at 20%. So that is a big difference
between the ordinary income tax rate, which caps
out at 37%. So that's a potentially 17 % difference.
You also have the ability if you're an investor
to do a 1031 exchange. If you're a dealer, you
aren't allowed to do that. You're not allowed
to defer gains that you get from something that
you sell. You also are not subject to self -employment
tax. Because the IRS looks at you being a dealer
as a business, they will treat you as if you're
self -employed. So if I buy a house and I flip
it and I make $50 ,000, they're thinking that
that's actually income from a business and not
just capital gain from an activity that you are
investing in. So they'll look to add in that
additional 14 .13 % tax on top of your profits.
If you are an investor, you can actually depreciate
your properties. because they're not looked at
inventory and you are subject to quote, unquote,
weird tear over time, the IRS will allow you
to depreciate the value of your property, which
is one of the big benefits of real estate is
being able to have a non -cash tax deduction
that you're able to claim to offset any income
that you make. Also, if you're an investor, you
could qualify for the QBI deduction and you may
not. It just depends once again on your facts
and circumstances. However, on a negative front,
If you're an investor, you could only deduct
up to $3 ,000 of capital losses. This is very
similar to if you own the stock and you sold
it at a loss, you can only use that loss to offset
gains from other capital assets that you own,
or you can only deduct up to $3 ,000 of your
ordinary income. So if I sell a stock for $10
,000 or I sell a property at a $10 ,000 loss
and I make $100 ,000, I can only deduct $3 ,000
against my income, any... lost over and above
that threshold will have to be carried forward
to a future year, which speaks to why we talked
in a previous episode about why you need to look
at your last year's tax returns to determine
if there's something you need to carry forward
to future years. Also though, if you're an investor,
you may pay that 3 .8 net income tax. We'll get
into this on a future episode and kind of dive
into more of the nitty gritty part of this. But
if you're a higher income earner, which is Julie,
as the IRS defines it, more than 200 ,000 single,
more than 250 married. If you have investment
income. then you will be subject to paying an
extra 3 .8 % on any investment income you make
that is above the 200 or 250 ,000 dollar limit.
So if you make 300 grand as a married couple
and you have investment income that exceeds that
by 50 ,000, you're going to pay 3 .8 on the lower
of your investment income or the amount above
the threshold. But importantly, if you're an
investor, you could pay that if you're a dealer,
you don't pay that. Also, the selling expenses
that you have, if you're an investor, they're
gonna be added to your basis normally, and they
will reduce your capital gain versus if you are
a dealer. those expenses, depending on how you
look at it, they're just going to reduce your
actual income. So the value of the expenses that
you deduct is going to be higher. This has a
byproduct of it's considered a business expense
versus a capital expense or an investment expense.
So the value of the deduction could be slightly
higher, especially if your tax bracket is on
the higher end. Now that we got into what a dealer
is, what an investor is, what the tax impact
of each will get into, how do you determine whether
you are what you are? Now this is one of the
things where it's important to have conversations
with your tax advisors ahead of time because
your intent is not always how the IRS will interpret
your actions. The more you give them information
to help dictate your intent, the more you'll
be able to back up a claim for why you did what
you did. I'll give you an example of that in
a bit when we go through this tax court case.
But when you're thinking about how do I determine
if I'm a dealer versus an investor, I'm gonna
look at eight different things. So I'll go through
these one by one. Number one is your intent when
you bought the property. Were you planning to
flip it or were you planning to rent it? If you
were planning to do one or the other, you need
to document that at the beginning. Also the number
and frequency of sales. If you every month are
thinking, hey, I'm gonna buy this investment
and hold it, but then I immediately sell it.
three months later and I have this pattern of
doing that, even though you allegedly had the
intent to hold it for investment, the IRS isn't
probably gonna see it like that if you're doing
this consistently. Also, how did you improve
the property? If you put a whole lot of money
into it upfront, normally people do that because
they're wanting to sell it pretty quickly. If
you just bought it and you put some lipstick
on it, then you may not be looking as if you're
trying to sell it at a much higher value than
what you bought it at. Also your marketing. How
aggressively are you trying to sell the property
once you bought it? How big and complex was the
deal? Is it large scale? Is it kind of a one
-off thing? How did you acquire the property?
If you acquired it via inheritance or via gift,
you're probably not going to be considered a
dealer in that circumstance. And then how long
you held it. If you've been holding this property
for longer than a year, that's going to give
you a lot better perspective that you are looking
to hold it for investment versus you just being
a dealer. If you're selling it after three months
or six months, then you're more likely going
to be looked at as a dealer if you're doing that
consistently and you don't have a lot of the
other factors that are on your side. And then
how much of your income comes from selling? Once
again, if you're trying to get out of your current
job and you're looking to use real estate as
your occupation, and all of a sudden your house
flips becomes a primary driver of how much money
you're making, then you're probably going to
look at as a dealer. Now, ironically, you can
be both depending on the type of property that
you have. For example, you could flip a house
in the same year that you buy a long -term rental.
And so it's really going to be on a case -by
-case basis, a property -by -property basis so
that you will determine, am I being a real estate
dealer in this case or am I being a real estate
investor? Which is why you need to, number one,
have objectives on the front end of why you make
decisions that you do. But then secondly, how
does the property you purchase feed into that
objective? And then you could define to say,
hey, The goal is to buy this house and to be
able to make a 30 % profit on it when I flip
it. That's very clear. You're probably acting
as a dealer in that case. Now, if you do this
one time, I will tell you, if you're just trying
to do a house flip here and there, I'm going
to be treating you as an investor from a tax
standpoint, more than likely. If it's just something
you did one or one or a lot, like I'm not looking
at that as a business. You started, if you just
got an opportunity to buy a house for cheap and
then sell it, we're going to look at that as.
you being an investor. But if you're doing this
consistently, then you want to be documenting
your thesis or your reason for buying on each
property that you have. Now, if you are an investor
and you don't want to be looked at as a dealer,
then you're going to want to do a few things
to help make sure you have that distinction to
say, hey, I don't want to pay self -employment
tax on these deals that I'm doing. I don't want
to pay. the extra income tax potentially on the
deals that I'm doing. So you're going to want
to keep a separate account for each property
that you have. So for example, my investment
properties, they go in one LLC. My flip properties,
they go into another one, if you put them in
an LLC at all. You'll also want to name that
LLC tied to what its purpose is. For example,
if I have a long -term rental, I might have ABC
investment rentals. That would be the name, or
I may have something related to investment in
the title. Also, I wanna use third -party brokers
or agents. So I don't wanna be marketing this
property myself because that looks like I'm actually
in the business of selling real estate personally.
You also wanna document your intent. So keep
your corporate books, keep your meetings. We've
talked on previous episodes about you don't have
to do those meetings locally. You can travel
and do them. That gives you an avenue to create
some additional tax deductions potentially, but
keeping that corporate formality to where you
could document what you did and why. will help
you ultimately increase the amount of tax transactions
that are available to you. Then you're going
to want to deduct your expenses on schedule E.
You're not going to want to deduct your expenses
on a schedule C or anything else if you are considered
an investor. And then you're going to want to
check your time. Investors usually spend less
time on a property than a dealer does because
they're not looking to try to immediately sell
it. So they don't have to spend a whole lot of
time on that property. One other thing to keep
in mind, though, is if you buy a property with
one intent, and then you change your mind, you're
going to want to document that change of heart.
All right. So obviously as humans, we struggle
with this. Think DeAndre Jordan, who would you
have a change of heart? But if you do have a
change of heart, just make sure you document
it so that, hey, if I sold this and IRS wants
to question me, I can point to, hey, you know
what? I was going to buy and flip this property,
but I couldn't sell it. So now I'd listed it
for rent. And even if let's say someone came
and bought it after the fact. you still have
a decent argument to say that, hey, I did flip
my strategy and then someone came and unbeknownst
to me made an offer that I couldn't refuse. All
right. So it's important to document, document,
document, get an idea of what was in your head
because the IRS doesn't know what's in your head.
All right. And so you're not in a relationship
here, so people can't read your minds. So it's
important to document that so that your intent
is clear and you can always back that up and
hopefully save you some money and keep more money
in your pocket. Now, a few other things as we
look to wrap up shortly. So a dealer, they're
gonna report their income on the schedule C.
And so that's where you're gonna see that self
-employment tax generated from a schedule C.
an investor is going to report their capital
gains on schedule D and then their actual income
on schedule E. So you'll have those two separate
things that really start with you working with
the tax professional or you, if you do it yourself,
make sure you report it in the proper way so
that the IRS doesn't get the wrong idea. Now,
why is this important? Because let's just say
you're in the top tax bracket, you're a high
income earner already and you go do a flip project,
but it was like a one -off time. And let's say
you made a hundred grand on that project. Well,
if you pay capital gains tax, you're only going
to pay $23 ,800 on that flip property. However,
if you're considered a dealer and you're in the
top tax bracket, you would pay upwards of $51
,000 in taxes. That's a $27 ,000 difference.
So that would get someone's attention as to why
they want to make sure they, number one, work
with someone who is competent that can give them
the right information so they report it accurately
and appropriately, but also why they would want
to make sure they know this. because ultimately
it will keep more of what you earn. So finally,
dealers buy to sell, investors buy to hold. Your
intent, activity, and frequency of sales will
help determine which one you are. The tax differences
are big relative to investors only pay capital
gains tax versus dealers will pay self -employment
and ordinary income tax. Dealers though do not
pay that extra net investment income tax. So
something to keep in mind because who wants to
pay extra tax? that they're not entitled to already.
But it's important to document what you're doing,
keep separate records. So if you have investment
properties, keep that on one end. If you have
flip properties, keep that separately. Now, if
you are a house flipper and you are doing this
quite a bit and you have enough profit, then
you might actually consider holding your flip
properties in like an S corporation. that will
help reduce your self -employment tax. So that's
something we'll get into in a future episode
as far as S corporations and when you might decide
to do that. But that is a strategy if you are
a house flipper or a land developer or someone
in that space where you can use an S corporation
to help shield you from paying as much self -employment
tax as you would otherwise. So let's get into
a tax court case. There was a guy by the name
of Mr. John D. Byron. And this case went to trial
back in the 70s. And so between 1971 and 1973,
Mr. Byron was killing it. He sold 22 pieces of
real estate, making him $9 million with a profit
of 3 .4. Now, it wasn't a matter of his profit.
It was really about, was he considered a real
estate investor or was he considered a real estate
dealer? So although in this case, it only took
three, four years for him to do this and he sold
22 pieces of real estate. And obviously the IRS
is thinking, hey, Mr. Byron, you're considered
a dealer. You're doing this frequently. However,
the court found that he was actually holding
these properties for investment purposes. And
so instead of paying ordinary income plus self
-employment on that 3 .4 million, he only was
subject to paying capital gains. So big win for
Mr. Byron. Now the reason that they were able
to distinguish this is because he was able to
show his intent behind holding them for investment.
He showed that he made no personal effort to
initiate the sales. He didn't advertise them.
He didn't have a sales office. He didn't hire
a broker. He just kind of listed them like any
other investor might. And he didn't actually
look to improve the land that he did. He bought
it. He held it. Someone offered him a price he
couldn't refuse and he sold it. Also. Even though
there were 22 sales over three years, the court
determined that this frequency alone did not
compel an inference that their properties were
held primarily for sale in the course of the
business. And so seven properties a year might
be a lot, but they didn't feel that that was
so many that he was actually doing it on a frequent
basis. He was just trying to buy and flip, buy
and flip, buy and flip. All right. And it also
showed that he didn't really spend a whole lot
of time. in this investment. So Mr. Brown was
was actually in a good spot, right, making three
or four million dollars, which, you know, mathematically
he was making over 150 grand a deal, roughly.
And so he was doing very well. It's just he was
spending a whole lot of time doing it. So he
must have obviously gone through his investment
filter and it spit out nice results. So this
shows you that, yes, the IRS is not always correct.
But if you want to beat them in court, if it
came to that. You don't want to have proper documentation.
You're going to have to back your case with prior
case law or what the law actually says. And ultimately
you have the ability to win. And as our motto
says, keep more of what you earn. So thanks for
listening to our episode. Be sure to like and
share it if possible so we can get more people
out there who are trying to quote unquote, stick
it to the IRS for lack of a better term. And
we look forward to talking with you next week.