capital gain or business income

[chanp]

Hello all,

I am new to S corporation.

I have a client with a S corporation. S corporation had purchased 5 real estate properties and spent 3 to 10 months to remodel them in late 2009 and during 2010. All were sold in 2010. My clients are retired and hired contractor to do all the remodel works. So, they did not spend more than 750 hours in it during 2010.

My questions are:

1. are they investment properties (capital gain) or inventory properties (business income)? What is the cutoff line?

2. if they are investment properties, can they deduct the property tax, insurance and utilities during the remodeling period? If not, can they capitalize it and add it to the cost of investment property? or no deduction nor capitalized at all?

3. One of the properties had a loan and paid interest in 2010. There was no investment income in 2010. So, how should I handle the loan interest?

Thank you so much for any advice and help.

[Pacun]

How much money/profit are we talking about? I know that mortgage interest will be added to the basis or deducted. It will never be ignored.

What did you clients did for a living before the S corportation? What do they do now? What was their intent when they formed the S corportation? Was the intent in accordance with what happened? Is the S corportion still in existence?

I am pretty sure I can come up with more questions... lol.

[chanp]

Hello Pacun,

Thank you for you reply.

We are talking about $100K gain in 2010. He is about 60 years old and does not have another job. The S corporation was set up in 2003 to sell internet domain name. It is still selling it but the sales is not good at all. It made a $6k loss three years in a roll. The S corporation started buying old house, fixing it and the selling it. The corporation is equally owned by my client, his wife and his son.

Thank you

[jainen]

>>are they investment properties<<

Pacun has some great questions! Besides the total gain, I ask about two ratios. How big an increase in value was it, and what part of that can be attributed to the repairs? For example, if they made a 30% profit that probably far exceeds the market increase, but if they barely squeeked out 3% then there isn't much business purpose in it. In any case, short term capital gain is taxed pretty much the same anyway unless you're trying to soak up a bunch of old losses.

[chanp]

Hello Guru,

Basically, they bought an old house or fixer and then sold it at 15-20% gain. I know that if it is business income, you cannot all the expenses related to the property such as insurance, property tax, utilities ..... If it is classified as investment, I think you can capitalize the repair cost but not insurance, property tax and other misc fees/expense.

Thank you

[samingeorgia]

Based on my interpretation of the facts you posted:

1. The corporation is not in the trade or business of remodeling houses,

2. The owners are not building contractors by profession,

3. The properties were remodeled by outside contractors, and

4. The properties were held for a relatively short time.

I would say that the cost of these properties should have been shown as "Other Assets" on the balance sheet and not shown as inventory. All costs, including insurance and taxes, would be included in this "Other Asset" category and will reduce the gain on the sale of the properties. The sale should show as capital gain and flow to the shareholders' returns as such.

Although, since the holding period is so short, the gain will be short term. I don't think it will make a big difference unless they have a big capital loss which could absorb the gain, or if you are worried that IRS would complain about an S corp. with $ 94,000 profit ($100K gain on the properties minus $6K loss from running the business) and no salaries to the owners.

[chanp]

Hello samingeorgia,

Thank you for your reply.

I have one question. How to justify to capitalize the insurance, property tax, utilities cost and other cost into the cost of property? Those are the running cost to keep the property but the property does not produce any business income. They are not a capital improvement cost because they do not increase the value of the property.

I will tell my client to pay some salary to themselves in the future.

Thank you

[Pacun]

I have one question. How to justify to capitalize the insurance, property tax, utilities cost and other cost into the cost of property? Those are the running cost to keep the property but the property does not produce any business income. They are not a capital improvement cost because they do not increase the value of the property.

The same way you "capitalize" the cost of transportation and insurance of a product during a transition state. You add that cost to cost of goods sold or to the cost of the product.

[chanp]

Hello Pacun,

I am still confused. I can see the point if the property is considered as inventory. However, if the property is considered as investment, I think you can only capitalize the cost to increase the value of the property. For example, it will include the remodeling cost, inspection report, building permit, utilities during the remodeling period...but insurance and property tax do not increase any value of the investment property. They should offset any investment income rather than capitalize to the cost.

What do you think?

Thank you

[samingeorgia]

Chanp, when you are involved in long-term projects, especially construction projects, you need to capitalize costs that you and I think of as "operating" or "period" costs until the property is placed in service or sold. This is based on the principal of matching costs and revenues. Imagine that you had one project in your business, a high-rise office building that will take two years to build and get ready for occupancy. You will be paying lots of construction period interest, insurance, and property tax. These would be added to the cost of the building until you reach a certain percent occupancy.

I hope this is clear; it's 5 AM on the east coast and I'm waiting on the coffee....

[Pacun]

Hello Pacun,

I am still confused. I can see the point if the property is considered as inventory. However, if the property is considered as investment, I think you can only capitalize the cost to increase the value of the property. For example, it will include the remodeling cost, inspection report, building permit, utilities during the remodeling period...but insurance and property tax do not increase any value of the investment property. They should offset any investment income rather than capitalize to the cost.

What do you think?

Thank you

Samin gave a good explanation.

Here is another logic. Let's see if this helps you. You add cost NOT only to inventory but to items that will help you make money. Let's say that you purchase a machine (which we know it is not inventory), again you add transportation cost and insurance. Investment property is somewhat similar to inventory or machinery, which have an end goal to help produce money. You would said that investment property could cause a loss and machinery not... we have to think again, what if you have a machine a nothing to produce... that machine will cause a loss. How about inventory that spoils? How about machinery you purchase and is down most of the time because it needs repairs. My answer is not from books but from logic so that you understand that you "capitalize" or add to cost any cost that cannot be deducted during the period. Most of the time when you dispossed of the property, you alculate the total cost.

[chanp]

Hello all,

Thank you so much for your explanation. I get it now and am sorry for the confusion.

Have a nice day.