TAX HACKS: How to Escape a Crippling Tax Burden When Selling Owner Financed Land
One of the biggest kick-in-the-gut moments I had in my first year as a land investor came around tax time.
I had sold my first few properties with seller financing, and because of how my business worked, the IRS considered me to be operating as a real estate dealer and not a real estate investor.
According to the IRS, a real estate “dealer” is one who buys and sells property “in the ordinary course of their trade or business.”
In other words, they buy a property with the intent of reselling, rather than with the intent of holding it for long-term cash flow and appreciation.
If you’re one who flips houses, land or any other type of property – chances are, you’re a dealer too.
What’s Wrong with Being a Dealer?
Being a dealer isn’t automatically a bad thing, but most real estate investors don’t want to be classified this way because when their properties are seen as “inventory” by the IRS (instead of as a passive investment), they will lose out on some notable tax advantages that real estate investors normally benefit from.
One of the more notable advantages a dealer cannot take advantage of is when they sell properties through an installment sale.
- When you’re taxed as an investor, the taxable income you make from an installment sale is taxed based on the cash received each year in proportion to the total sale price.
- When you’re taxed as a dealer, the taxable income you will eventually make from ALL of the future payments in that installment sale is due immediately in that first year, not over time, as it would be for an investor.
For example, let’s say you’re selling a property for $20,000 in an installment sale. You collect $2,000 at closing and you create a note for the remaining $18,000 balance, to be amortized at 8% over 10 years.
You aren’t going to collect more than a few thousand dollars in that first year, because most of these sale proceeds will be paid to you over the next decade.
Regardless of when you’ll be collecting that money, the IRS doesn’t care. If they think you’re a dealer, you will have to pay the full tax bill for that ENTIRE $20,000 sale price (plus interest) in that first year, even if you’ve only collected a tiny portion of the money so far.
Depending on how much you originally invested in the property, and depending on your tax bracket, you could easily owe more in taxes than you’ve collected in that first year, putting you in a negative cash flow position in year one.
Obviously, this is a horrible deal for a dealer, and it can easily get worse.
What if you’re selling ten or twenty properties like this per year? Now you could be losing A LOT of money, after doing a lot of hard work to pursue a good business model.
Is it a ridiculous rule?
Of course.
Is there any way to get around this?
If you’re selling vacant land, you might just be in luck…
The IRS Loophole for Land Investors
REtipster does not provide legal advice. The information in this article can be impacted by many unique variables. Always consult with a qualified legal professional before taking action.
I’d like to point out a section from 26 U.S. Code § 453.
Like any section of the U.S. tax code, this is a giant, confusing labyrinth of tax and legal language that basically requires an attorney or CPA to decipher, but there is one important section you should take a closer look at.
If you scroll down to sub-section (l)(2)(B)(ii)(II), you’ll find a place where it clearly spells out a few types of installment sales that are NOT considered to be a “dealer disposition” and thus, isn’t subject to the immediate taxation punishment normally inflicted on real estate dealers.
Carefully read the words in bold below…
(2)Exceptions
The term “dealer disposition” does not include—
(A)Farm property
The disposition on the installment plan of any property used or produced in the trade or business of farming (within the meaning of section 2032A(e)(4) or (5)).
(B)Timeshares and residential lots
(i)In general
Any dispositions described in clause (ii) on the installment plan if the taxpayer elects to have paragraph (3) apply to any installment obligations which arise from such dispositions. An election under this paragraph shall not apply with respect to an installment obligation which is guaranteed by any person other than an individual.
(ii)Dispositions to which subparagraph applies
A disposition is described in this clause if it is a disposition in the ordinary course of the taxpayer’s trade or business to an individual of—
(I) a timeshare right to use or a timeshare ownership interest in residential real property for not more than 6 weeks per year, or a right to use specified campgrounds for recreational purposes, or
(II) any residential lot, but only if the taxpayer (or any related person) is not to make any improvements with respect to such lot.
If you’re selling a residential lot in an installment sale, this is a big deal.
In my first year as a land investor using seller financing, my former accountant (who was not a land specialist), gave me some pretty bad news about how much money I would have to pay in taxes that year.
After a short panic attack, I, fortunately, recalled hearing about this special exception for residential lots and, after I showed it to them, they came back and said,
“Oh, okay. Nevermind.”
Now, I’m not giving out tax or legal advice here. I’m not an attorney or tax expert, and if read through 26 U.S. Code § 453, you’ll see that there’s A LOT of information there.
Are there other things you should pay attention to if you want to avoid being pegged as a dealer? Yes. For example,
- This exception doesn’t include the transfer of a property to a domestic corporation as described in section 381(a).
- In other words, don’t sell the property to a corporate entity in the U.S. if you want to avoid the dealer status.
- The property must be unimproved land that doesn’t change.
- In other words, you cannot improve it or subdivide it, and your borrower shouldn’t alter the property either, or it will fall under the dealer status.
- The property must be residential.
- In other words, don’t do this with a commercial or industrial property unless you want to be labeled as a dealer.
Again, I’m just re-stating my non-legal, layperson’s interpretation of what I see written in the code, so don’t take my word for it.
If you decide to pull out this code and show it to your accountant at tax time, be sure that you and they read all about it yourselves to make sure you fully understand what is and isn’t allowed, and whether your properties will pass the test.
