Real property, merchandise, inventory

[Deborah Drexler]

I keep hearing people say on BP that property is considered "inventory" when it is bought and sold by a  house flipper.   The corollary to that is that one must report the value of beginning and ending inventories on one's Form 1120 and must track "cost of goods sold." 

Something about that didn't seem right to me.  As a lawyer (but neither a health care nor tax lawyer, so I may very well be in over my head) I took a look at tax court cases and found a consistent theme:  courts holding that real property is never considered to be "merchandise" and thus cannot be inventory.  The leading case on this is Homes by Ayres v. Commissioner, 795 F.2d 832 (9th Cir. 1986).   As far as I can see this case has never been overturned and the principle still stands. 

So it seems to me that what a flipper should do is capitalize all costs related to each parcel of real property, adding it to the parcel's basis, and thus recovering the value of these costs upon sale of the property.  (And of course any gain is taxed as ordinary income).  I believe that this achieves basically the same result as treating real property as "inventory," is easier, and to me makes a lot more sense. 

Anyone want to comment on this?