if you’re in the business of flipping, materials and supplies purchased in advance are still deductible. If the materials are used for the fixup they are included in the COGS. There is absolutely no requirement that materials be purchased after the house. It’s all “inventory.”
Supplies, also. If you use supplies in year 1, but don’t sell the house until year 2 - still deductible in year paid.
If you are flipping property, all costs directly attributed to the property are accrued until the property is sold, including supplies purchased specifically for the subject property. These costs are included in the Cost of Goods Sold and are not recognized until the year the property is sold.
Tools purchased for the business and used in other properties could be a deductible business expense.
It’s not so black and white, says the Internal Revenue Code.
There are a set of rules for businesses keeping inventory to follow called the Uniform Capitalization Code (UNICAP). UNICAP requires the capitalization of most costs directly related to the underlying flip / rehab property, and like any other capitalized costs, you don’t receive the deduction until you sell the property.
Notice I say [i]most[i] costs. Exceptions:
Real Estate Taxes
Advertising / Marketing Expense
*** For the first three, the IRS permits you to immediately deduct interest / insurance / taxes paid on a flip / rehab property in the year paid, regardless of whether the property was sold or carried forward as inventory. These costs are considered “holding costs” of inventory and are not capped.
In short, most costs directly related to the flip you’re working on are capitalized to the property and not deductible until the year of sale. As John in NC mentioned, the same rules apply to rental properties until the moment they’re ready to be rented (i.e. advertised openly to tenants).
Under Reg. 1.263A-2(b)(3)(iv) , a manufacturer that uses the simplified production method and, during its tax year, incurs total indirect costs of $200,000 or less may treat its additional Section 263A costs as zero.
I am not a CPA and I am having a little trouble following this discussion.
My reference is IRS Pub 538, Accounting Periods and Methods, which says
Uniform Capitalization Rules Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for production or resale activities. Include these costs in the basis of property you produce or acquire for resale, rather than claiming them as a current deduction. You recover the costs through depreciation, amortization, or cost of goods sold when you use, sell, or otherwise dispose of the property.
Activities subject to the rules.You are subject to the uniform capitalization rules if you … Acquire property for resale.
Nowhere in the list of exceptions to the Uniform Capitalization Rules in Pub 538 do I see Mortgage Interest, Insurance, Real Estate Taxes. or, Advertising / Marketing Expense specifically mentioned.
Whether these costs are included in the cost of goods sold seems to depend upon whether they are direct costs. It seems intuitive to me that the mortgage interest paid on the loan used to acquire the property held for resale (flip property) is a direct cost. The hazard insurance premium and real estate taxes attributable to the property acquired for resale would also be direct costs. Following the same logic, marketing expenses incurred to sell the dealer realty also would be a direct expense.
Since the mortgage interest, hazard insurance and property taxes are only paid while I own the property, aren’t these direct costs also holding costs? Additionally, any money I spend on the maintenance and upkeep of the property during my holding period to include supplies that become a physical part of the property (such as light bulbs) are other holding costs that I would include as direct costs which I would also add to the cost of goods sold in accordance with the Uniform Capitalization Rules.
From my reading, Pub 538 disagrees with your guidance. Maybe I don’t know what a direct cost is.
direct costs are “parts” (& labor to install parts.)
Costs like taxes, interest & insurance are sometimes directly attributable to a project, and sometimes not. I call these holding costs, even though they may also be direct costs.
indirect costs are management, overhead. (there is a list: google Section 263A)
In an ideal world, all direct costs would be added to inventory. IRS has rules, section 263A, that provides for the allocation of a portion of indirect costs to inventory. These allocated costs are removed from expense and added to the cost of manufactured inventory.
a 263A calculation is a real pain, and from a client’s point of view, expensive for me to do.
There is a lower threshold for small businesses so that they do not have to allocate these indirect costs to inventory: $200,000 of indirect costs per year.
Realistically it is medium to large manufacturing operations that fall under these rules. It would be a rare real estate investor who would have that kind of indirect costs every year.
Thus, what I do (and you may disagree) is ignore these indirect costs. Parts is parts and goes into the inventory/COGS of the house. Other stuff is other stuff and gets expensed when paid. I also treat holding costs as incurred when paid, even thouth they may technically be direct costs. Any difference is immaterial.
I include all direct costs – costs to purchase, hold, and maintain a flip property – in the cost of goods sold. Since these costs would not be incurred if I did not own the property, they are direct costs.
Indirect costs are essentially my office overhead expense. Office staff (salary and benefits), office supplies, office utilities, repairs, office equipment lease, even business vehicle expenses are included in overhead. The rent I pay for my office space, or if I own the building, the mortgage interest, property taxes, and hazard insurance I pay for my office space are all overhead costs. These costs are the indirect costs that are not attibuted to s specific flip property and which I would claim as office expenses in the year incurecd. I have these costs whether or not I have any flip property on hand.
It sounds like you and I are both on the same page.
A caveat to the original question; I currently live in the property which I am incurring costs to rehab for a rental property. Can I continue to track expenses for getting the property “Rent Ready” which I will advertise after I close on my second property and soon to be primary residence?