Connections for Success

 

08.19.15

Tax Court Considers House Flipper’s Expense Deductions
Michael Kovacs

With many real estate markets on the rebound, real estate investors are resuming house-flipping strategies.  Investors must keep in mind that in order to deduct expenses related to the property, the expenses must be incurred in connection with a “trade or business.”  And, as the taxpayer in the recent case of Ohana v. Commissioner ( Nos. 16014-11, 25896-11, May 8, 2014, U.S. Tax Court) learned the hard way, a trade or business requires more than just vague intentions to sell at some point.

Flipper Claims Expenses

In 2005 and 2006, the taxpayer bought houses in Saratoga and Palo Alto, California. He initially lived in the Saratoga house and rented the Palo Alto house.

During that time, he worked full-time in an executive position requiring long hours and extensive travel. (See our previous blog on the real estate professional rules.)  Nonetheless, the taxpayer claimed to run a real estate business in which he planned to make money by flipping houses: that is, buying a house with the intent to fix it up and sell it at a profit. To avoid the risk of a down market, his strategy was to move into the house and live in it until the market was more favorable.

The taxpayer bought the Palo Alto house with the intent of tearing it down and building a new one. On the recorded deed, he checked a box indicating he intended to eventually make the house his primary residence; he also obtained a residential mortgage for the construction. In late 2009, he moved into the new Palo Alto house and rented out the now-renovated Saratoga house.

The taxpayer claimed more than $280,000 in non-rental expenses in the years 2007 to 2009. The IRS filed notices of deficiency disallowing all of the claimed non-rental expenses, and he appealed.

Tax Court Weighs In

The U.S. Tax Court weighed whether the taxpayer’s activities amounted to being in a trade or business. To be engaged in a trade or business, a taxpayer must be involved in the activity in question with continuity and regularity for the purpose of garnering income or making a profit.

Although the taxpayer in this case was heavily involved in his real estate projects, he wasn’t continuously or regularly involved in the business of buying and selling real estate.  The court noted, he didn’t sell or buy a single property during the relevant period.

The Tax Court also found that the taxpayer’s primary purpose in engaging in the real estate activity wasn’t for profit, but was for providing a home for his family or for rental income. It first considered the Saratoga house, observing that — though the taxpayer had begun to rent it out in 2009 — he’d never tried to sell it. The court added that the taxpayer had failed to properly maintain records of any of his expenses for the home, so the deductions would have been denied for lack of substantiation.

As to the Palo Alto house, the taxpayer argued that the expenses incurred in building the new home weren’t personal because he intended to make a profit on its eventual sale. At best, these costs should have been capitalized until such time as he did sell the house.  The court noted, referencing a prior case, if hoping to eventually sell a house at a profit was sufficient to establish a profit-making intent, “rare indeed would be the homeowner who purchased a home several years ago who couldn’t make the same claim.”

Regardless, the facts showed that the taxpayer had always intended to make the new Palo Alto home his personal residence. When he bought the property, he told third parties it was to be his primary residence. He enrolled his children in the Palo Alto school system for the 2008 and 2009 years. And, his loans were the type one would obtain for a primary residence.

The court also pointed to “minor touches” that made the house less marketable for sale and more useful for the taxpayer. These included a custom-built door with a peephole low enough for the 5-foot, 4-inch taxpayer to see out of it.

We have several clients who have serially lived in a home for two years while they fixed it up and then took advantage of the $250,000 ($500,000 for married filing jointly) gain exclusion when they sold the home.

Look Before You Flip

House flipping may seem like an easy path to great profits, but that’s not always the case. While this case is rather extreme, we see clients wanting to deduct expenses that fall outside a “trade or business” every year.  If you have questions,  contact Michael Kovacs at mkovacs@orba.com or call him at 312.67.7444 or contact your ORBA CPA to discuss what expenses might be deductible, what expenses might be able be capitalized into the basis of the property and which are clearly not deductible at all. Visit orba.com to learn more about our Real Estate Group.

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