Real Estate Sales & Self-employment Tax

Mr. Anonymous, after reading Poor College Student [see comments] asked:

Wow--could the same apply in real estate transactions? I bought 3 properties a few years ago with extra money I had saved, held them relatively short-term and sold them at a profit. Had no clients---just myself making money for myself. This was my only income I had that year.

Accountant classified me as Self Employed, I paid IRS. IRS audited me last year and I assessed substantial additional taxes and penalties as Self Employed on those properties' sales. Was I really not SE, is the IRS wrong, and/or did my accountant unintentionally help me believe I was, therefore possibly misclassifying me in the first place?

Mr. Anonymous maintained his privacy but lost the opportunity to get a good answer from me because I can't get in touch with him to get clarification on his situation. So instead of directly answering his question I'll give you all some info on being self-employed and owning real estate. And, I also hope this will give you some guidance on how to ask a question.

Mr. A said there were "real estate transactions" on "3 properties" held for a "relatively short-term."

Real estate transactions: Hmmm ... could be buy, sell, trade, or exchange.
Three properties: Barren islands off the coast? Residential rentals? Golf courses?
Relatively short-term: Never relative. It's specific. One year or less is short term. More than a year is long term.

With real estate you have three, well sort of three, possible tax treatments:

1. Income from the sale of real estate held as investment property is taxed using capital gain and loss rules.

2. Rent received from rental property results in rental income, which is ordinary income.

If you are a real estate professional then any loss from renting property may have a more advantageous tax treatment.

If you are a real estate dealer, depending on your intent for holding the property -- rental income or investment profit -- it may also be subject to self-employment tax.


3. Rental property with services you provide is self-employed income.

You buy land in Santa Fe. Do nothing with it. Sell it two years later. That was an investment. Just like buying and selling stocks. It is not self-employed income.

Rent that you receive from tenants less rental expenses leaves you with rental income that is taxed as ordinary income. It is not self-employed income unless you provide services such as cleaning, linens, meals, etc. for your tenants. Here's an example:

• Mike Mobile had a sizable piece of land near the lake. He let visitors park their campers there for a fee. He provided no services. The fees he received were rental income not self-employed income subject to S-E tax. Within a few years the spot had become so popular that he added some amenities and raised the rent. He provided things like a laundry facility, fax and phone line hook-ups in the main office, fresh water, etc. Now he’s receiving income as a self-employed.