Most wholesalers or those wanting to get into wholesaling may be new in business, not just the real estate business but business in general. Significant mistakes are made when someone jumps into business without knowing some basic business requirements.
When an individual transacts business transactions they may end up being identified legally as “Being in the business of” something and unaware that their legal and tax status being different than someone who might enter into the same kind of transaction.
When you are considered to be a “Dealer” or “Operating” a business your legal status changes under the Tax Code and under laws applicable to that type of activity.
A simple example might be with garage sales. You hold a garage sale for 3 days, you might need a permit or give notice to the city, but no business license is required nor are you required to acquire special licenses. Now, hold your garage sale for 30 days, remain open to sell used goods and you can be considered being in the business of dealing in used goods. If you have a couple of used car batteries for sale, you might need permits and licenses dealing in such materials when you’re in the business of selling batteries.
The IRS is generally the authority we look to define a business activity rather than a business transaction. When there is not a clear cut definition for individuals conducting some function in the law, regulators, law enforcement and government agencies look to the Tax Code to define a business activity from a business transaction as being engaged in “the business of” doing something.
The Courts have basic tests of determining if someone is in the business of doing something as opposed to carrying out a transaction. Much of this rests in a determination of intent of the taxpayer or the party involved and there are key areas that are considered to determine a business activity.
First question is what was the purpose and use of the asset purchased, held or sold?
Next, how many transactions were accomplished and the frequency of transactions?
The time and effort employed to facilitate transactions is a factor.
What does the individual (or company) ordinarily do and what was the income from the transaction(s) compared to their primary income is considered.
Was any advertising used, if so to what extent will also be considered.
There are other factors considered as well that determines if someone is a “Dealer” in real estate or an “Operator” of a business concern. Obviously, if the transaction was accomplished in a business name then two other aspects will be looked at.
Does the company, in its formation set by any declaration a business purpose that is or is related to the transaction accomplished? If you formed an LLC and stated in your business purpose that you will conduct real estate activities, or the buying, selling, trading of an asset, and your transaction involved that type of asset, you’re in the business of dealing. Now, if you own a music store and have a real estate transaction in the name of that business, more than likely you’re not considered to be in the real estate business.
I mentioned the time and effort aspects for a determination and in real estate there is a Real Estate Professional test, a “Test of Hours” that is generally available for landlords and professionals. This places you squarely in being in “the business of” real estate.
While there can be other tax aspects for a hobby or home business or second small business, real estate laws and other aspects of law can become applicable with one transaction. In real estate it’s pretty black and white, you’re either in the business or you are not. Being in the business you will have more compliance matters than if you are selling your own home.
A wholesaler who flips or assigns real estate contracts is not usually taking on buyer or seller responsibilities as to tax matters, but they can as to other real estate requirements as the contract represents an equitable interest in real estate with a purchase contract.
From a federal viewpoint, as under uniform law, when a purchase contract is executed an equitable interest in title is conveyed to a buyer but legal title is conveyed at settlement of the contract to purchase. When you sign a purchase contract as a buyer you take an equitable interest in title to that property.
A wholesaler using a purchase contract is acquiring and selling title interests in real property. You’re not just flipping paper! Being “in the business of” flipping purchase contracts puts you in the real estate business. You are providing a service, you are not considered an “investor” for tax purposes or legally under applicable laws, but you are a “Dealer” or an “Operator”. I’m not going to touch on what people call themselves or what might be socially acceptable on the internet or how you describe yourself to your friends and relatives being an “investor”.
But, for the sake of being politically correct on the internet, we’ll just call the “dealer” or “operator” an “investor”. Wholesalers simply need to understand where they sit when it comes to taxes and laws.
Let’s set aside real estate a moment for a example in business. If you acquire contracts to buy pork bellies (or any commodity) and you purchase with your own money for your personal use, that is a consumer transaction. If you buy with your own money to hold the contract to sell back to a securities dealer, you’re an investor. But, if you are in the business of acquiring contracts with the intent of selling the contract to another consumer or as a business, you’re now a commodities dealer, that requires a license from the Securities and Exchange Commission. You are brokering contracts for pork bellies.
Back to real estate, as to licensing matters for a wholesaler, you can draw your own conclusions, prudently I hope, as being in the business of real estate is much different than conducting one transaction because you changed your mind in a purchase contract.
Said another way, if I contract to purchase a house and then I find a much better deal and would rather buy that other property my intent has changed. Let’s say I can’t buy both properties. I have an investor friend who I know would like the first house I have under contract. I’m a landlord, not acting as a business of a wholesaler. I could assign my contract and probably stay away from technical regulatory concerns or going to jail.
However, when my dealer status or investor status moves into being in the business of wholesaling, rules, regulations and laws become much more applicable to my transactions. State laws vary, but from a federal aspect, you have passed the intent of being in the business to make a profit.
The purpose of this article is to point out the nature of being in business rather than dealing for yourself as a capital investor, doing things over and over again for a profit rather than a one time transaction.
As I mentioned, as to any real estate license, you can make that determination, perhaps it would be wise to consult with an attorney.
Don’t forget other business requirements as well. You’ll probably need a business license. You can be fined operating any business without a license. If you ever end up in court and you don’t have the proper licenses, your case can be tossed out or you may lose failing to conduct business legally.
Estimated taxes needs to be addressed with your accountant, harsh penalties apply when you aren’t paying taxes as everyone knows.
Check on any ordinances concerning door to door sales, you’re selling a service, you’re not acting personally being in business.
Review Truth In Advertising Laws, the Federal Trade Commission has a good website explaining what is acceptable and what is not concerning the advertising of services, real estate is covered under the FTC. Look to the Fair Trade Act as to pricing and valuing services in a business.
So often I see posts in the forums asking for contracts for some transaction. New investors simply must do a quick read of the basics of contract law, what elements must there be for a valid real estate contract. Contracts are basically under uniform law but each state has requirements for those in the business of conducting real estate transactions.
Being in the business you can consider your contracts as a type of inventory, that is really what your business is anchored in to sell your services, if you don’t have a valid contract in your jurisdiction you can’t enforce your contract which means you can lose lots of money. You may even be fined for not making certain disclosures or using a state approved contract in you business. As you inventory, your contract will be used many times if you remain in the business, so it is well worth spreading the cost of an attorney to review your contracts over the time you’ll use them.
Understand what dealing in “good faith” means with the parties are fully informed as to the promises made and expectations implied. Expectations of fair dealing are anchored in the basics of real estate and valuations of real property as well as services need to be understood by those in the business.
The last point in this article is that new investors attempting to wholesale need to understand they are not to advertise a property they don’t own as being for sale, this is a violation of uniform and real estate law, it can go to fraud trying to sell something you don’t have title to. Again, state law varies. Wholesalers are selling a contract or the right to purchase a property, not the property.
Future articles will touch on basic business law and how real estate transactions may be governed. I will also cover ways to transact business that avoid the legal and ethical issues of wholesaling, how to take title and sell as an owner instead of simply facilitating a transaction.