There is potentially a huge difference in taxation between a real estate dealer and a real estate investor. A dealer is taxed on his net income (income less costs) at ordinary tax rates and could also be subject to self-employment tax on this income. An investor is taxed on net income at capital gains rates. If he owns the property for more than 12 months, then the maximum tax rate is 15%. Plus, he can do a like-kind, or 1031 tax-free exchange of the property into a new property. And there is no self-employment tax for an investor. So the goal for every property owner is to have as much gain as possible from their property taxed as investment, or portfolio income.

Nick has been talking to his tax advisor who has painted the following scenario for him. Nick is asking me whether it works. (Seems perhaps like Nick is not entirely confident in his tax advisor and now wants a second opinion. Nothing wrong with a second opinion. I do wonder if you want a tax advisor in whom you are not entirely confident.) Here is Nick’s specific situation and his advisor’s recommendation:

Q: Hi Tom: Nick here again. I have been recently informed by my tax advisor that being a real estate "dealer" is NOT a good idea and we should try to avoid this status labeled by the IRS if at all possible. I understand there are ways to try to prevent the IRS from labeling my business as a real estate dealer (I currently wholesale and retail contracts/deals). One technique suggested by my tax advisor was to create two entities. The first entity would be a C-Corp. This entity would enter into all contracts and transactions. The second entity would be a LLC taxed as an S-Corp. My LLC would charge my C-Corp a fee to find and manage the deal. Example: Let’s say I (My LLC) finds a great wholesaling deal. My C-Corp enters into Contract and closes on the deal. The profit from said deal is $150,000. My LLC would then charge my C-Corp a fee of $150,000 which zeros out the profit/loss from the C-Corp thus I avoid having to pay any taxes on the C-Corp entity. Since my LLC is taxed like a S-Corp, I would deduct all expenditures ($25,000), then pay myself a salary ($25,000) and take the rest ($100,000) in dividends. Is this a viable tax strategy? Can you provide some light on this and let me know if it's okay to structure my entities this way? Thanks in advance! – Nick

A: The first challenge, of course, with this answer is whether the IRS will allow a shifting of the entire profit from a deal away from the company that did the deal (the C corp) into another company. Why would the C corp even do the deal if there is no profit? I’m not quite sure why you even need the C corp. Why not just have the S corp do the deal and not worry about the IRS? No difference in outcome. BTW, this doesn’t avoid the S corp from being a dealer and recognizing ordinary income. Other than reducing self-employment tax (which I like), I’m not sure what this structure does for you.

There are ways to split the baby, so to speak, so that some of the income is taxed as capital gain while the rest is taxed as ordinary income. For more about this, come to the Rich Dad Education Tax and Asset Protection course. You can get more information on this course by sending an inquiry to cs@provisionwealth.com.

Warmest regards,

Tom