The tax codes differentiates between 4 types of real property:

1. Primary resident – This will be your principal resident, place where you actually live for most of the year.

2. Secondary home – This will be a place you live in addition to the primary resident (place you spend few weeks every year)

3. Rental property – this will be property that generates rental income / loss

4. Investment property – this will be property you buy, remodel and sell (“flip”)

If you fall under the 4th category you are dealing with investment property. When it comes to such property, the tax code requires you to add all the cost and expenses associated with the project to the cost basis of the property and not to claim it as deduction on your schedule A or Schedule E of form 1040.

What it means is, that instead of claiming the mortgage interest against your other income (on schedule A) you have to add the interest expenses to the purchase cost of the house. Claiming the interest on schedule A or schedule E is only allowed for Primary or Secondary home and for Rental property, but not for investment property.

When you sell the house, you will be allowed to deduct all of the expenses that you were not to claim on schedule A or E against the sale price of the property. The difference between the sale price and the purchase price including all the expenses will be defined as your capital gain and taxed accordingly (if you held the property 12 months or more, you will only pay 15% long term capital gain tax, and you if held it for less than 12 months, the short term capital gain tax will be added to your wages, interest and any other ordinary income and will be taxed based on the applicable tax rates for that tax year).

You will have to report the sale price, the purchase price and associated expenses, the capital gain and if it’s long term or short term, on schedule D in the year you sell the property.

What if you are doing the “flip” with a partner?

You have two options here:

1. Report 50% of the sale price, the purchase price and associated expenses, the capital gain and if it’s long term or short term, on schedule D in the year you sell the property; Or,

2. Since you may form a partnership – you can file IRS form 1065 to report 100% of the sale price, the purchase price and associated expenses, the capital gain and if it’s long term or short term, on schedule D in the year you sell the property and issue form K1 from the partnership to you and your partner, showing each partner’s share of the capital gain and if it is long or short term.

In both options, you should clearly document:

1. Your business arrangement

2. Proof of payment of any of the expenses you pay for

3. All transactions, expenses, bills and receipt related to this project.

4. Account of the capital gain calculation If you have the above, you could support your claim that you are a partner in this project and therefore entitled to offset any expense you paid for again your share of the sale price.