Business or investment?
When preparing the tax return for a taxpayer who buys and sells real estate, it is important for tax purposes to determine if the taxpayer is an investor in real estate or is operating a business that buys and sells real estate. The difference between the two affects how gains and losses are treated, whether or not the return will include additional taxes such as self-employment tax or the net investment income tax, the calculation of QBID, and the calculation of credits that are based on earned income.
Thus, it's important to correctly determine whether or not a taxpayer's real estate buying and selling activity is a trade or business, irrespective of how the taxpayer self-identifies, e.g, "investor", "house flipper", etc.
For the purposes of IRC section 162, a trade or business is an activity conducted with continuity and regularity and has as its primary purpose earning income or making a profit. In determining whether or not an activity rises to the level of being a section 162 trade or business, the IRS takes into account all the facts and circumstances, e.g., the manner in which the taxpayer does their work, the amount of time and effort they put into it, the amount of profit they earn in relation to both their losses and their investment, et.al. See Treasury Regulation section 1.183-2 here for more information and a discussion of each of the factors the IRS considers.
Where to report in the tax return
A taxpayer who is a sole proprietor and whose business is buying and selling homes should report that activity on Schedule C. The homes they purchase, improve, and offer for sale will be their inventory. Since it's a business, they will be able to deduct the usual and customary business expenses related to this activity.
On the other hand, if their activity buying and selling real estate is not a section 162 trade or business, report the activity on Schedule D. The costs to improve and sell a home will be added to its basis. Since the home is a capital asset and the activity isn't a business, the taxpayer won't be able to deduct the usual business expenses related to the activity.
Note: This is a brief guide on how to report house flipping in an individual tax return. It is not intended as tax advice.
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