Tax rules every house flipper and builder should know

Real estate clients who flip houses or build new construction face complex tax reporting rules that directly impact self-employment tax, inventory accounting and cost allocations. From determining dealer versus investor status to applying the right rules for depreciation, your guidance can be the difference between a smooth filing season and an unexpected liability.

Q: If painting occurs during a remodel, is it currently deductible under §162 or must it be capitalized under §263(a)?
A: Routine painting that merely keeps the property in ordinarily efficient operating condition is a current deduction under §162. Painting is capitalized under §263(a) when it is part of a betterment, restoration or adaptation, such as when it is integral to a larger improvement. Apply the tangible property regulations and consider whether the routine maintenance safe harbor applies.

Q: Is mortgage interest deductible for a taxpayer engaged in house-flipping activity?
A: Interest properly allocable to the production of real property must be capitalized under §263A(f) during the production period. After the production period ends, business interest may be deductible, subject to the limitations in §163(j).

Q: When does §162 apply? It defines “expense,” but the underlying concept is unclear; please clarify.
A: Section 162 allows a current deduction for ordinary and necessary expenses paid or incurred in carrying on a trade or business. After identifying an expenditure as an expense, test it under §263(a) and the tangible property regulations. Capitalization is required if any betterment, restoration or adaptation criterion is met. In practice, start with §162, then apply §1.263(a)-3.

Q: If a taxpayer invests through a pass-through LLC entity, how is the activity reported on the owner’s Form 1040?
A: If the LLC files as a partnership or S corporation, the determination is made at the entity level and passed through on Schedule K-1. If the entity is flipping properties, ordinary trade or business income (K-1, Box 1) flows to Schedule E, Page 2. Partnership amounts may be subject to self-employment (SE) tax, while S corporation pass-through amounts are not. If the entity is an investor in property, capital gains and losses flow to Schedule D (and Form 8949, if required). For rental real estate (K-1, Box 2), the income or loss flows to Schedule E, Page 2, and the passive activity rules under §469 apply; use Form 8582 as applicable.