Flip/Interest Tracing questions

[Zee]

I have a client that used the proceeds of an S-Corp residential rental property equity loan to purchase another home (not included in the S-Corp) to fix-up and flip. I assume all of the fixing-up expenses need to be capitalized? What about the interest? Is it investment interest, or must it be capitalized as well. Or, since he only has one primary residence does it make sense to treat this as a second residence? I should add he's informed me this is his first/last venture into flipping.

[Bees Knees]

With the exception of the home mortgage interest rules, interest must be traced to the use of the loan proceeds. So if you take out a loan on S Corp owned residential rental property to fix up and “flip” another home not owned by the S Corp, the interest is traced and deducted against the flip home. Capitalization rules do not apply unless the taxpayer is subject to UNICAP.

I’m not even going to address the issue that the taxpayer is using equity in an S Corp owned property to purchase non-S Corp property. Gee, I wonder if I could get my neighbor to let me use the equity in his house to take out a loan so I can buy a car?

What’s the difference?

As to deducting the interest as home mortgage on a second home, that would not apply unless the taxpayer uses the residence as a second home.

As to the first and last “flip,” I never believe anyone who says this is the only “flip” they will ever do. I tend to say it is a Schedule C business unless they are on their death bed and won’t live long enough to ever do a second flip.

[Zee]

With the exception of the home mortgage interest rules, interest must be traced to the use of the loan proceeds. So if you take out a loan on S Corp owned residential rental property to fix up and “flip” another home not owned by the S Corp, the interest is traced and deducted against the flip home. Capitalization rules do not apply unless the taxpayer is subject to UNICAP.

I’m not even going to address the issue that the taxpayer is using equity in an S Corp owned property to purchase non-S Corp property. Gee, I wonder if I could get my neighbor to let me use the equity in his house to take out a loan so I can buy a car?

What’s the difference?

As to deducting the interest as home mortgage on a second home, that would not apply unless the taxpayer uses the residence as a second home.

As to the first and last “flip,” I never believe anyone who says this is the only “flip” they will ever do. I tend to say it is a Schedule C business unless they are on their death bed and won’t live long enough to ever do a second flip.

Bee Knees-

Thanks so much for your prompt response. However, I'm not sure I fully understand your answer. The home is "investment property", right? As such, the interest would be "investment interest"and subject to the limitations on deductibility, right? The house was "gutted". I would assume the remodeling costs would all be capitalized, right? Of course, the taxpayer gave me a long list of mileage trips which I indicated weren't deductible at all.

Last, I do think this is their last "flip" for sure. They feel "burned" and "stretched" financially. We're in Florida, the market has cooled substantially such that their "flip" will most likely be on the market a long time.

As to the equity loan on the S-Corp property, go figure. That's what the $5,000 Donald Trump seminar must have suggested (LOL). Once this tax return is completed, they want to liquidate the S-Corporation.

[Bees Knees]

In my opinion, this is a business, not an investment. A flip requires a substantial amount of labor to fix it up. I assume your client did alot of the work. That is a business, not an investment. It is very difficult to prove it is a one time deal and therefor not a business. That is something the courts sometimes rule on, but not always.

As far as the remodeling costs, of couse they would be added to basis. The house is treated like inventory. As such, the mileage for the trips would be deductible.

The S Corp loan also indicates it is a business, not an investment. S Corps are not in the business of loaning money for shareholders to make personal investments. They are in the business of making money as a business, and so that would be another reason why this is a business, not an investment.

I draw the line at the client’s personal involvement with providing services. If the client is doing a lot of the work to make the flip profitable, it is a business. I don’t care that he says it is a one time deal and won’t ever do it again. He provided his own labor to make a profit. An investment generally requires little labor.

[Zee]

In my opinion, this is a business, not an investment. A flip requires a substantial amount of labor to fix it up. I assume your client did alot of the work. That is a business, not an investment. It is very difficult to prove it is a one time deal and therefor not a business. That is something the courts sometimes rule on, but not always.

As far as the remodeling costs, of couse they would be added to basis. The house is treated like inventory. As such, the mileage for the trips would be deductible.

The S Corp loan also indicates it is a business, not an investment. S Corps are not in the business of loaning money for shareholders to make personal investments. They are in the business of making money as a business, and so that would be another reason why this is a business, not an investment.

I draw the line at the client’s personal involvement with providing services. If the client is doing a lot of the work to make the flip profitable, it is a business. I don’t care that he says it is a one time deal and won’t ever do it again. He did it to make a profit, not hold on to something as an investment.

Thanks again for your opinion and input. I guess I just don't feel as strongly as you do on that the activity is a "business". In fact, with today's RE market in Flordia he may be holding on to the property for some time before it will sell. Was his "intent" for this to be a business? I think so. Is this his last "flip"? I'm sure it is. He's now working full-time for a large corporation and regrets ever having started this endeavor. In fact, they will probably be moving from Florida to Denver.

If we treat this as a business, would the demolition costs of gutting the home and the interest be deductible?

[Bees Knees]

Again, I put more weight on his personal activity than whether or not it is a one time deal. Even if it is a one time deal, he still contributed personal services to the activity.

Interest is currently deductible. Demolition costs must be added to the basis of land (TTB p. 8-6).

[Zee]

Again, I put more weight on his personal activity than whether or not it is a one time deal. Even if it is a one time deal, he still contributed personal services to the activity.

Interest is currently deductible. Demolition costs must be added to the basis of land (TTB p. 8-6).

Bee Kness, please accept my apologies for the lengthy question/answer session. Now, I'm wondering if I chose the right term. "Gutting" or "removing" the interior walls of a home isn't really the same as "demolition" of the structure. I can understand the costs being allocated to the land when that's about all that's left. But, it doesn't seem to make a lot of sense that the labor costs of removing and hauling away the interior of a building should be capitalized as part of the land (but lots of IRS rules don't make sense to me). It would seem that the capitalized as part of the building. I do wish someone else would chime in here, so I didn't have to bother only you with this exchange. Thanks for the courteous answers.

[Bees Knees]

I miss read your post. Gutting the interior of the home would be part of the re-construction costs. Since it is major improvements, it is added to the basis of the home (not the land). Deductible as COGS when the home sells.

Don't worry about bothering me. I've been tied up with a BIG return all day and I'm sick of working. Just thought I'd come on here and find someone to argue with.

Where's OldJack or Armando?

[BOB W]

I have .....

.... never expensed any area of a flip other than RE Taxes. Every dollar spent I put in basis, including interest.

[Bees Knees]

.... never expensed any area of a flip other than RE Taxes. Every dollar spent I put in basis, including interest.

I agree that interest is added to basis...under UNICAP (TTB, page 8-15). However, TTB, page 8-14 mentions home construction contractors that complete construction within 2 years with less than $10 million in gross receipts as not being subject to UNICAP.

[Zee]

I agree that interest is added to basis...under UNICAP (TTB, page 8-15). However, TTB, page 8-14 mentions home construction contractors that complete construction within 2 years with less than $10 million in gross receipts as not being subject to UNICAP.

OK. Thanks again for the prompt replies.

[BOB W]

I never..........

..... claimed to do it right, but you asked for other opinions.

[Zee]

..... claimed to do it right, but you asked for other opinions.

Yes, what's right doesn't aways equal what's done in the tax business for practical reasons.

[Davc]

I agree that interest is added to basis...under UNICAP (TTB, page 8-15). However, TTB, page 8-14 mentions home construction contractors that complete construction within 2 years with less than $10 million in gross receipts as not being subject to UNICAP.

The rules are different when you own the property. "Self constructed "assets require basically everything to be capitalized during the construction period.

[Zee]

The rules are different when you own the property. "Self constructed "assets require basically everything to be capitalized during the construction period.

That makes sense, thanks for pointing it out to those of us trying to better understand this situation. Although "self-construction" wouldn't apply to remodeling or fixing-up property for resale, I can think of situation where this would be good to know.