Intent to flip - converted to rental

[thetaxman2200]

Hello all,

I have a client who purchased a home in '05 with the intent to flip. They recorded the property and the improvement as inventory. Since they started to rent the property in 2011 - I need to convert the property to a rental with depreciation. Question is this still inventory that depreciates? Do I move in from inventory to a fixed asset for depreciation purposes? Do I need to show Cost of Goods sold for this?

Thanks

[Gary2]

Is this the only property that they purchased with the intent to flip? Or are they in the business of flipping real estate?

[thetaxman2200]

This is the only property

[JoshinNC]

Inventory?

If client only intended to flip one property then why isn't this a Schedule D investment with no reporting until sale? Of course, once it became a rental all costs are part of depreciate basis and it goes on Scedule E.

[thetaxman2200]

I should have mentioned - they have set up a LLC for this situation. It is a dual members LLC

[Gary2]

Have they been filing a 1065 for the LLC all along?

[thetaxman2200]

They have - problem they had the property listed as Inventory as you would if your where flipping the house - I am assuming I have to move from inventory to an fixed asset!

[Gary2]

So they've been filing a 1065 for all these years showing no income, no expenses (except perhaps tax prep and annual LLC fees), and inventory with the taxes, insurance, and other costs capitalized into its value? At least, I believe the costs and carrying charges associated with the property have to be capitalized, but I may be reading things wrong.

My inclination is to agree with Josh, that this never should have been treated this way. I vaguely recall another thread here where people argued reasonably that the 1065 was required because of the LLC, but I don't recall it being a compelling argument, so that I wasn't convinced.

But having done it this way, I believe the choices are either to treat it as an adjustment to opening inventory, with an attached statement (similar to charitable contributions) or as a distribution with a corresponding contribution back. I'm not sure if the latter will trigger anything that would require recognizing income (or if it would trigger the IRS to inquire about it, even if the answer is no). Either way, COGS should be zero, since there were no goods sold.

This assumes that the rental is indefinite and not merely incidental to it being part of inventory. And, of course, there are all sorts of other issues concerning rental income and passive activities.

[Burke]

Like many others who own real estate they cannot sell, I imagine they are renting only due to this fact. Which means they will sell as soon as the market improves. Need to explore intent in this case and whether they are still holding it out for sale. But changing it, of course, is to their advantage since it takes ord income subj to SE tax and converts it to cap gains with no SE tax issues. I would suggest they keep it this way for at least 2 years or more to avoid recharacterization if it were challenged by the IRS.