The first part of this question is mostly directed towards Seth or someone in his capacity. I am looking for a recommendation for a CPA to work with that clearly understands land investors. Specifically, someone who can help me avoid falling into the IRS’s “dealer” category, as well as other various tax pitfalls. I should mention this will be the first time I’ve worked with CPA.
The second part of my questions also relates to the Dealer category. I want to make sure that I understand correctly- as long as I don’t sell my land to a business and I don’t buy any land that’s zoned as commercial, I should be good?
I’ve never spoken to a CPA about it, I’ve just researched this on YouTube, so take this for what it is, but this is how I understand it. This has to do with how your income is classified. There’s two types of real estate income involved here, active and passive. If you flip land, wholesale, fix and flip, develop property - that is all active income. It’s taxed as ordinary income and you have to pay self employment taxes on it (the extra 15.3%). If you have long term rental income, that is considered passive income. It’s still taxed at your ordinary income rate, but you get all the awesome benefits of writing off the depreciation of the asset - which could be a significant tax savings. You also get to do 1031 exchanges.
If you have both active income flips and rental properties, you run the risk of being classified by the IRS as a dealer, which means ALL of your real estate income is classified as active, you have to pay self employment income on it, and you don’t get to depreciate your rental properties. AND you don’t get to 1031 exchange it.
I haven’t been able to find an answer to how the IRS determines this, how it’s triggered, how long it lasts, nor can I find anyone who has actually been tagged as a dealer. From what I understand (from the internet) if you report all of these assets on your personal 1040, essentially if you are filing as a sole prop, listing the details of everything, this might raise a red flag. All of your individual properties show up there. The recommendation is to never have active income (land flips) and rentals in the same entity (or personally). You should put your rentals into an LLC taxed as a partnership, which sends you a K1 (it’s a summary of your passive income and therefore doesn’t indicate the details of all your rentals). And you should put your active income into an s-corp or a c-corp. The s-corp sends you a K1 as well (hiding the details of your activity), and the c-corp is it’s own thing. And by hiding, I don’t mean that you are literally hiding it, but by moving the details of this income off of your personal tax return, you are reducing your risk of getting this classification. But I would be curious to hear what a CPA that has actually dealt with this would have to say. I’m not sure this is super common.
@isaakberry I totally understand the concern and why you’re asking, but it’s not really a CPA’s job to change your classification from a dealer to an investor. It has everything to do with what you’re doing, how long you’re holding each property, who you’re selling it to, etc (I don’t even fully understand all that goes into it, to be honest… I’m not a CPA).
It’s also possible (normal, even), to be labeled as a dealer on a property-by-property basis, depending on what you’re doing with each individual property (e.g. - the IRS might consider you an investor for any rental properties you own long-term, while simultaneously considering you a dealer for any properties you flip in that same year).
In my experience, a CPA can advise you on what you need to change in order to not be labeled as a dealer, but it’s ultimately up to you. If your business and your actions put you squarely in line with a “dealer” according to the IRS, your CPA won’t be able to change this. It just is what it is.
The second part of my questions also relates to the Dealer category. I want to make sure that I understand correctly- as long as I don’t sell my land to a business and I don’t buy any land that’s zoned as commercial, I should be good?
Are you referring to the issue of being taxed for the entire gain on a seller-financed property in the first year? If so, that’s my non-CPA understanding. Of course, this isn’t tax advice, you’d have to confirm this with a CPA to be sure (note: for what it’s worth, I’ve never heard any CPA say anything to the contrary about this).
@billwalker thank you for your response and insight. I should have mentioned that I actually do not have any passive income properties so based upon what you are saying, all my income will be categorized as active income and taxed with an additional 15.3%?
@retipsterseth thanks for the response. I should have clarified; I don’t have any properties quite yet as I am just beginning my first direct mail campaign. That being said, I am not looking for a CPA to “change” how the IRS considers my income that I haven’t earned yet. I think my question really is, will I face heavy tax penalties being solely a land flipper? Your response to the second part of my original question makes me feel as though I’ve missed the mark entirely. I seem to have thought that no matter what, as a land flipper, I would be treated as a land dealer regardless of if I offered seller financing. Is this incorrect? I hope what I am asking is making more sense now. I apologize for the confusion.
Essentially at the end of the day I just want to make sure I’m laying the legal groundwork properly to best position myself to avoid any huge tax penalties for this type of work. I try to closely emulate your successes that you had in the early days of your land business.
@isaakberry If you are flipping land as a business, it is considered active income. Active income is taxed at your tax rate, and in addition, you will have to pay “self employment” tax which is an additional 15.3%. This is your FICA tax. Normally at your day job, you will pay 7.65% right off the top and your employer has to pay 7.65% also. So, since you are “self employed”, you get to pay the whole thing = 15.3% tax. And we are talking about profits here, not total revenue (you get to write off all the expenses like closing costs, mailers, data, etc.)
This active business income applies to pretty much every business out there. In the real estate business, the types of activities that are considered active are thing like flipping land, wholesaling, fix and flips, and real estate development. Any activity where you are putting effort into the business or adding value to a property. It’s income where you aren’t “passively” sitting back and collecting a check.
You could make an argument that if you only did one or two of these short term land flips, that it wouldn’t be active income. It could be a short term capital gain (and you wouldn’t have to pay the self employment tax on it.) But if you plan to do more than a few of these types of deals, then you should plan on paying this tax. There is nothing tax advantaged about this type of business. But the profit margins are so high that it doesn’t matter.