“Real estate investors” do not exist!
Not for the IRS, anyway. But before we turn attention to the almighty IRS, let me share some mean-spirited general comments. Ten years ago, the title “real estate investor” actually had some meaning and respect, and it almost had to be earned. Like, for instance, you would have to complete couple deals before calling yourself an investor. Not any more. Anyone who attended at least one real estate-themed gathering instantly becomes an investor. I’m not sure, maybe even attendance is no longer a pre-requisite. Watching some cheesy TV show might suffice. I must be a cowboy, since my kids have some cheap cowboy hats, and I watched a few Clint Eastwood westerns. Howdy!
Ok, I’m done offending you and not planning to take away your ribbons, but let’s agree on the definition.
Who is an investor?
A real estate investor is someone who invests money in owning real estate. Are we in agreement so far? The key word here is owning. At some point, an investor should actually own real property. No property ownership – not an investor.
This seemingly simple definition excludes many entrepreneurs who work with real estate. For example, realtors are not investors – as they do not actually own properties, they simply arrange real estate transactions. Of course, realtors can also be investors, in addition to being realtors, provided they buy some properties for their own portfolio.
More controversial, but very important exclusion is wholesalers. Per my definition, wholesalers are not investors. Yes, they are in real estate business. So are realtors. In fact, the primary difference between realtors and wholesalers is that realtors are licensed and usually work the retail market, while wholesalers are not regulated and usually serve investors. Otherwise, they do the same job: match buyers with sellers and get paid whenever a match results in a closed deal. Neither realtors nor wholesalers take ownership of the properties – so they are not true investors. We would not refer to caddies as “golf players” or to flight attendants as “pilots”, right? They do very important jobs, but different jobs.
If you agree with me that wholesalers should not be called investors, then you should easily agree that contractors, handymen, lenders, attorneys, inspectors, etc. are not investors, either. They are all legitimate and respected businesses (except maybe attorneys) – but they do not own real estate and therefore cannot claim to be investors.
But I do own properties! I am an investor, and I exist.
Again, not for the IRS. What we were discussing so far was a common-sense definition. Common sense and tax law (or any law, for that matter) are not compatible, as your parents sure warned you. Try finding an IRS form or an IRS booklet that mentions “real estate investors” – you will not find any.
The tax law, so thoughtfully written for us by Congress, recognizes two distinct businesses that real estate investors can be involved in:
A. Resale business (fix and sell).
This is the business of buying something for X dollars and selling it to somebody else for Y dollars, pocketing the difference. Essentially the same business as car dealers, grocery stores, or ticket scalpers. Flipping houses fits right in.
B. Rental business (buy and hold).
This is the business of acquiring something, holding on to it, and charging other people for the temporary use of your property. If it reminds you of hotel operations, car rentals, and tuxedo rentals – you’re on target. Landlords will find themselves under this general umbrella.
The trouble is that these two businesses are controlled by two totally different sets of tax rules and are expected to use totally different IRS forms. So, which one is yours? Well, this naturally depends on which of the two businesses you run – a resale business or a rental business? Are you a flipper/reseller or a landlord?
I know that you want to slap me across my stupid face and scream that you are an INVESTOR! We already established that. The problem is that you cannot slap the IRS – they will slap you back harder. Scream all you want, but there are no tax rules and no tax forms for investors. There are rules and forms for resellers, and there are different rules and forms for landlords. Who are you, sir?
Choosing your hat.
Even if your therapist insists that split personality is ok, it’s not ok for the IRS. They need you to determine which of the two camps you belong to. No “independent” candidates here. I will do my best to help you make this confusing choice.
The most important factor, from legal perspective, is your intentions. Specifically, how did you intend to make money from your properties? (Hint: if you’re not sure what your intentions are, ask your wife. Somehow, she always knows.)
Since you attended all these workshops and training webinars, you can probably give an hour-long lecture about all the different ways to get insanely rich insanely fast in real estate. A sharp investor is supposed to make money when buying property, while holding, when selling and even while sleeping. It’s all cool, but we’re talking about fundamentals.
Traditionally, landlords count on two primary ways to make money. One is month-to- month passive income from cash flow. If everything is working right, you should be collecting rent every month, and that rent should cover your mortgage payment, taxes, insurance, repairs, and everything else – and still leave you with some residual cash. This money is what we call cash flow. With one investment house, it’s usually not much to write home about, but it adds up as you buy more and bigger properties.
The second way to make money as a landlord is to let time do its magic, known as appreciation. Historically, most real estate becomes more valuable with time. So, if you wait long enough, and market does not mess with you (like it does nowadays) – you should be able to sell your property for more than you paid for it. Between ongoing cash flow and eventual profit from appreciation in property values, landlords should do well.
In contrast, resellers are not interested in waiting several years for the property to increase in value on its own. They want to sell right now and put some serious cash in their pockets immediately. Neither are they excited to deal with tenants, even if it would bring them a little extra cash flow. Sell as soon as possible and move on to the next property – this is the business plan.
To that effect, resellers have two primary ways to make money: one is the textbook buy low – sell high; the other is to increase the value of the property by rehabbing it. (I’ve noticed a recent trend to “buy low – sell even lower”, but this creative variation of investing seems to accelerate divorces, so I cannot endorse it.)
To sum up, landlords are after continuous cash flow and long-term appreciation. Resellers are after quick resale profit, often from making improvements to the property.
What are you after? If you have an answer – great. Then you know which of the two hats you are wearing. Certainty is nice when available. Just ask the politicians.
Two hats, anyone?
Unfortunately, you may still be lost, because your business plan may be to grab any good deal that comes along and then figure out your exit strategy. If the property can be quickly and profitably sold, then this is what you will do. If it turns out to be a keeper, then you keep. Simple from business point of view; awfully complicated from the tax law angle.
See, the tax law requires that you state your intentions: do you plan to resell or to keep? are you a flipper or a landlord? yes or no? “Whatever” or “I want to keep my options open” are not acceptable answers for the IRS. Make up your mind, mister.
If you really do both kinds of deals – keep some and flip others – it is actually fine. What it means is that you run two different businesses: a reselling business and also rental business. You alternate between wearing two hats. The trick is to know which hat you’re wearing at any particular time. In other words, you must declare your intentions for each property.
I understand that this is not crystal clear still. I’ve talked to hundreds of investors over the years, and I fully appreciate the complexity of what you do. Often, it really is tricky to decide between resale and rental label. Hint: that would be a good time to give me a call.
Why even bother?
Good question. So what if you call it rental, and I call it resale? Same thing in the end, isn’t it? Not really. The two real estate businesses are taxed under very different systems. Which one is better, you want to know? Actually, neither. They are just different, and below is a short summary. Your mileage may vary.
Resale (flipping) business is an active business, reported on IRS Schedule C. The profits are taxed at your ordinary (meaning – high) tax rate, plus they are subject to additional self-employment tax that can be as high as 15%, on top of income tax. Resale properties are not eligible for depreciation, capital gains rates, installment sales treatment, or 1031 exchanges. Ouch.
Anything good? Yes. Such business is entitled to all business deductions, from home office to driving to Section 179 instant write-off. You can also set up various retirement plans and employee perks. Finally, if your flipping business is losing money, the tax losses are usually unrestricted.
Rental (landlording) business is a passive business, reported on IRS Schedule E. Almost everything we just discussed about flipping business is now backwards. No self-employment tax; capital gain rates when sold; depreciation, installment sales and 1031 exchanges are in.
However, many business deductions are out, at least partially; no retirement plans available; and losses may be restricted or even eliminated altogether.
I hope it’s now obvious that pledging allegiance to one type of business or the other is not something to take lightly. If you roll a dice, pick a heavy one. Better yet, pick up your phone and call your real estate accountant. Unlike “real estate investors”, we exist.