I recently got began looking at investing in real estate. My original intent was to rent with the possibility of selling the house a few years down the road. However, the first two houses I purchaed, I instead sold via owner-financing. Now, I’m being told two different senarios related to income taxes. One CPA says that I will be considered a real estate dealer and therefore have to report the total gain on the sale even though I only have a note that I’m holding, no money in hand. Another says that due to me holding the note, that is not the case and I can defer the gain and use the installment sale method to report my income. Besides being completely confused, my thought is to not do any further owner financing deals and focus on rental or lease to own and possibly avoid being labeled a dealer and instead an investor. My hope is that if I’m an investor I can use the installement method on the first two homes and defer the gain.
So which CPA is correct and what would be my best option related to income taxes?
dealer simply means that you purchased the properties with the intent to resell. facts and circumstances will determine if you, in fact, did have intent to resell.
did you advertise the properties for rent? did you accept tenant applications? did you interview tenants and conduct credit and/or background screens? These activities would indicate that you intended to rent the properties, irrespective of what you actually ended up doing with them.
If you did not, then it is likely that you were a dealer on these properties. This means that you treat them as inventory and the sale of the properties as business income. That’s ordinary income (not capital gain) plus self employment taxes. Figure about ~45% total tax bite on the gain. Be sure you calculate the gain correctly taking into account purchase price, any repairs/improvements you made and selling expenses (commissions, inspections, bank fees, etc). Everything that took money out of your pocket is deductible (except the loan, of course).
Business income is not eligible for installment sale treatment.
Don’t forget that the buyer’s interest to you is also income each year, and you should send them a 1098.
If, on the other hand, facts and circumstances indicate that you purchased the properties to rent (intent was to rent, even though you actually sold the investment properties) then you may be able to take capital gains (lower tax) and use the installment sale method.
Thanks for the quick response. Just to be sure, I have a note to the bank for $90,000 on the home. I’m financing a note to the buyer for $120,000 therefore I have to report the gain of $30,000 less business expenses and add the interest income. That amount will be subject to ordinary income and self-employment taxes? It sounds like I goofed and should instead do lease to own instead.?
The amount of your loan to the bank is not necessarily your cost basis. How much did you pay for the property, how much did it cost you to rehab, how much did you pay in holding costs until you sold the property? All of these elements are included in the “Cost of Goods Sold” and that amount determines your taxable profit.
In my opinion, a Lease To Own exit strategy would still make you a dealer to real estate and you would still have the same tax treatment.
If you want the investor tax treatment, put the property into service as a rental with the intent to hold it indefinitely. Use lease option exit strategy if you wish to unload marginal performing rentals.
don’t confuse cash with income, they are not the same.
income is a calculated value that takes into account everything that happens with the property, as Dave said.
Also, since you are “in business” don’t forget office or cell phone costs, birddog fees, mileage while you looked for the houses to buy, office expenses, etc. All business expenses are deductible to arrive at taxable income.