In Part One, we explored some ideas for converting your profits from ordinary income to long-term capital gains. The tax benefits available to home flippers also depend on proper accounting and recordkeeping to ensure you deduct all applicable expenses.
Start with Proper Recordkeeping
Your fix-and-flip project will have many expenses. To maximize your tax deductions, you need to keep good records, which involves the following points:
• Separate your business banking from your personal checking account. Commingling leads to confusion and possible tax problems.
• Keep separate accounting for each project.
• Keep all your receipts and document all expenses.
• Accelerate expenses so that they occur within the current year. If convenient, wait until the new year to close on the sale of the flip property.
• Carefully identify which expenditures are immediately deductible and which must wait until you sell the property.
Direct and Indirect Costs
Direct costs related to the purchase and rehabilitation of your investment property are considered capital expenditures. You must wait to sell the property to recoup capital expenditures, when you deduct them from the sale proceeds to reduce your tax-bite. Typical capital expenditures include:
• Purchase price
• Direct labor
• Direct materials
Direct costs go directly into property purchase and renovation. You do not expense these. Instead, you add them to the cost basis of your property. At time of sale, your taxable profit equals the sales proceeds minus the cost basis. By incorporating your capital expenditures into the cost basis, your
taxable profit is reduced, but only after the sale of the property. Indirect costs can be expensed before the sale of the property. If you run your fix-and-flip business from an office, all your office expenses are treated as overhead and can be immediately deducted.
This includes rent, utilities, insurance, and office supplies. For those of you who operate out your home, the IRS has made it easy to take deductions based upon the size of your workspace as a percentage of total space. For example, if you work out of your 1,500 square-foot apartment in a 150 sf office, you can deduct 10% of your rent, utilities and other costs that apply to your office. Of course, you can expense all costs associated solely with the office, such as internet, phone, printer, paper and ink. Other costs that you can immediately deduct include expenses on your vehicle to the extent you use it in your work, building permits, property taxes, real estate commissions, and legal/accounting fees.
Indirect costs reduce your taxable income for the year. If your expenses exceed your income, you have a net loss that you can carry forward to reduce future income. The same is true for capital losses, but unless you can qualify your property for capital gains treatment as discussed in Part One,
your property is considered inventory and gains are taxed as ordinary income at your marginal rate. If you can’t or don’t want to handle your accounts yourself, you will need to hire a qualified bookkeeper of accountant to keep your books in order and help file your tax return.