Reducing or eliminating capital gains: NO, it's not simple!

[Michael Plaks]

How do I deal with capital gains? - this is one of the most frequently asked questions on this BiggerPockets forum. The minute it is asked, investors jump in suggesting their pet strategy such as a 1031 exchange or a deferred sale trust or owner-financing. I'm pretty sure these tips are coming to this thread, too. Let me explain why they are not helpful.

You cannot have a "step by step" guide to dealing with capital gains. It would take a book, maybe multiple volumes, and still everyone's situation is different. But here's a start.

1. Do you even have capital gains? Many investors call all of their profits capital gains. Not so. For example, profits on flips are not capital gains in most cases. Capital gains is a concept for buy-and-hold properties, mostly rentals.

2. How much of a capital gain? It's not equal to the check you received at closing. The calculation can be tricky, especially for properties that were financed, refinanced, and depreciated for years, and often depreciated incorrectly.

3. How much would that capital gain affect your overall taxes if you do nothing? Surprisingly, sometimes the answer is - not much. Sometimes, it does not increase your taxes at all or even results in an overall reduction of taxes! And not only if it used to be your personal residence or if this is an inherited property. Even your "normal" investment property sold with capital gains might result in your total tax bill getting lower instead of higher. There're too many factors to mention that affect the end result.

4. If the impact on your total tax is significant, what are your overall investment and financial plans and current situation?

• Do you need access to the full cash amount from the sale? 
• How do you plan to use the proceeds? 
• What else do you already own or plan to acquire? 
• What are you planning to do with your other investments? 
• What else is going to change in your life and your finances in the near future? 
• In the longer future? 
• And how reliable is your crystal ball?

Until these questions are answered, suggesting any specific strategies (1031 exchanges, installment sales, trusts, and so on) is as useless as asking your buddies what prescriptions they are using for their conditions. You need to know your own condition first and ask your own doctor.

One more thing: sometimes you need to ask yourself whether you really should be selling the property.

[Michael Plaks]

Originally posted by @Tanner Sherman:

Are flips not considered short term capital gains because of that active participation, and thus becomes regular income? 

This is a complex topic on its own. If you do flipping consistently, you have ordinary business income that is taxed at regular income tax rates PLUS the 15% self-employment tax, which is Social Security/Medicare tax. One "casual" flip might sometimes be considered as non-business and qualify for short-term capital gain treatment. The income tax rates are the same as for ordinary business, but no self-employment tax.

This is not nearly as simple as I described above, and I do not recommend making a decision of short term capital gain v. ordinary business on your own. For most flippers, it is NOT capital gains.