There are two general approaches available to report your activities:
If you purchase a property as investment - the sale transaction is reported on the schedule D - short term (held less than a year). Some expenses - such as real estate taxes, mortgage interest - you would report on the schedule A; Any improvement expenses, utilities, etc would be added to the basis. As you did not use the property for business or rental - there is no depreciation and you do not need to use the form 4797. As you would have capital losses - they would offset any other capital gain you might have - if your net capital losses are above $3000 - only $3000 nay be deducted in the current year (2007) and the rest should be carried over to the next year. Please see Publication 550 (2007), Investment Income and Expenses
If you are in the business for fixing properties - the property you had is considered as inventory and all income and expenses should be reported on the schedule C. As you have losses - there will not be any self-employment taxes. There is no limit for deducting business losses, but if you report business losses in two out of three years - that may trigger the IRS audit. Please see Publication 334 (2007), Tax Guide for Small Business
Let me know if you need any specific forms or instructions.
You may treat mortgage interest either way - if that is a second home and you are not deducting mortgage interest for more than two homes you may deduct the same way as you are deducting your home mortgage interest.
The way you deduct will likely not affect your tax liability.
You are absolutely correct - that is not something new or that the IRS not aware of: if the taxpayer has losses it is preferable to treat them as business losses, but if there is a gain - it is more beneficial to have capital gains.
You also correct that the IRS is looking closely for such "tricks" and treating similar transactions differently may trigger the red flag. Will or will not that affect you - hard to predict. The larger time interval - the less possibility - but I would never rule it out.
There is three years statute of limitation for the IRS to assess additional taxes - assuming you filed your tax return and did not commit the fraud - it is unlikely that the IRS will audit tax returns for which the statute of limitation has run out.
Appreciate for accepting the answer and for bonus.
Please be aware that you are not absolutely free to decide how to treat your activity. If for instance, you would sell three properties during the year and make substantial gain that overpass all your other income - the IRS would treat your activity as a business regardless your past history.
You likely misunderstood the IRS agent. Real estate taxes are deducted as taxes on the schedule A and not as investment expenses.
If you treat the property as a second home (personal property) - you may deduct the mortgage the same way as a mortgage, but for investment property - that would be investment interest. Please consider this definition of the investment property - Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity). Investment property also includes an interest in a trade or business activity in which you did not materially participate (other than a passive activity). - while it sounds a little broad and allows multiple interpretations - we need to relay on it.
Investment interest is not limited by the mortgage, the advantage of investment interest treatment is that you may also include - for instance - a credit card interest that you incurred when purchased some materials for the investment property. Etc
Generally - and that is correct - your deduction for investment interest expense is limited to the amount of your net investment income. You can carry over the amount of investment interest that you could not deduct because of this limit to the next tax year. The interest carried over is treated as investment interest paid or accrued in that next year.
However - in the year you dispose of the obligation, or if you choose, in another year in which you have net interest income from the obligation, you can deduct the amount of any interest expense you were not allowed to deduct for an earlier year because of the limit. Thus - you may deduct the interest expenses in the year you sell the property.
Your investment expenses (other than interest expenses) must be ordinary and necessary expenses paid or incurred: -- To produce or collect income, or -- To manage property held for producing income.The expenses must be directly related to the income or income-producing property, and the income must be taxable to you. Expenses you had in connection to your activity do not meet the definition above - they are related to a specific property, and not to investment activity in general (to produce or collect income); and that is not income a producing property. So generally speaking - these are not deductible investment expenses. Moreover, expenses are related to a specific property - so such expenses are not deductible and should be added to the basis.
As you are in the gray area - and some items may have multiple interpretations - please provide all the information above to your tax preparer.
You should not be scared of the IRS - yes it is large and very bureaucratic organization - but the IRS doesn't have any intention to take anything from you and we should not blame the IRS for failed business venture...
Even if you would be audited - the auditor will not treat you as an offender and that might be a good learning experience as well.
I'm glad that you are optimistic and looking forward to use whatever you learned. You may look for combination of real estate activities - such as rental and reselling - based on market condition and timing.