Capital Gains Question

[Karen Bolyard]

Hello everyone,

I recently purchased a SFR as an investment property and started rehab this week. Trying to decide whether to flip or rent. I had originally thought I would rent for year and do a 1031 to avoid cap gains tax, but I was told since I am a real estate professional ( I am a broker), I would be exempt from cap gains. I had also heard I need to have several homes in an LLC to qualify. We have 4 SFR's- 2 in one LLC, 1 in a different LLC and 4th is my personal residence not in an LLC. Any advice / suggestions is greatly appreciated!!

[Joe Homs]

@Karen Bolyard OMG, I would love to live in your world.  I wish that were all true, but none of it is.  You make money and are expected to pay taxes.  Even a 1031 is just a way to defer taxes, but you will have to pay one day, unless you die.

Good Investing...

[Wayne Brooks]

@Karen Bolyard Whoever told you any of this has no clue of what they're talking about. "Real estate professional" status has no effect on this. Your understanding was correct and anyone can do a 1031, with just one property, no LLC, etc.

[Henry Clark]

OP.  On 4 your personal property you can avoid capital gains in your primary residence if you have lived there 2 of 5 years.  Single $250,000 gain or married $500,000.  
Depending on your personal life and your other properties, during the 5 year period you could live in 3 of your properties working towards this tax reduction. You must sell the first property though before you run out of year 5.  

Because you had this type of question which is good. Recommend you do a separate post and copy your LLC Operating agreement and ask if there are any ways to improve or concepts to check on.

These are all great items to go over now that you are starting to scale. Post on your insurance, financing, etc.  You’re already past the initial stages. Would ask readers to help you look at your operations from a scaling standpoint. 

[Account Closed]

Quote from @Karen Bolyard:

Hello everyone,

I recently purchased a SFR as an investment property and started rehab this week. Trying to decide whether to flip or rent. I had originally thought I would rent for year and do a 1031 to avoid cap gains tax, but I was told since I am a real estate professional ( I am a broker), I would be exempt from cap gains. I had also heard I need to have several homes in an LLC to qualify. We have 4 SFR's- 2 in one LLC, 1 in a different LLC and 4th is my personal residence not in an LLC. Any advice / suggestions is greatly appreciated!!

 Hey Karen, 

A misconception about the real estate professional status (REPS) is that you can be in a real property trade or business (in your case, broker) and still qualify. You also mention capital gains exemption which is not something here. 

To clear things up for you: 

Rental real estate activities are default passive in the eyes of the IRS. Real estate professional status is valuable because it allows us to reclassify these rental activities to active. Why would we want to do that? Because if we can take deprecation losses from our rentals, we can use that loss to offset our other active income (from being a broker for example). 

To qualify for real estate professional you need to 

1. spend 750 hours working in a real property trade or business  and more time in this then any other work activity. 

2. Materially participate in your rental activities 

How do we materially participate in our rental activities? 

There is a test for that. Technically there are 7 ways, but for our purposes, we want to pass one of these three: 

1. spend 500 hours materially participating in the rental activities 

2. Spend 100 hours materially participating and more time then anyone else involved (cleaners, maintenance people etc) 

3. Spend more time then anyone else doing all substantial services. (do ALL the work yourself) 

What is "materially participating"? We take this to mean (based on 100s of real tax court cases) any activities integral to the business of running a rental. Meaning: if the business can function without you doing it, IT DOES NOT COUNT! Education and research hours, "managing the property manager" all have failed under audit historically. 

There is a lot more nuance here I could go into, but I would strongly advice you talk with a real estate-focused tax professional. Not understanding and following the rules can cost you greatly. I hope this helps get your situation on the right track and gets the conversation going with your accountant. 

[David M.]

@Karen Bolyard

As mentioned, being a real estate broker doesn't automatically qualify you for the Real Estate Professional Status (REPS) ---- IRS chose such a bad name.  Certainly, working in real estate can help.

REPS doesn't exempt you from taxes...  It just lets you take any passive losses that year onto your 1040.  I should add, while that's CAN be nice to take losses/deductions, its better to actually be positive and make money.

If you flip, you are considered dealing in inventory, not an investment property.  As such, the profits are taxes are ordinary income subject to self-employment tax.  Also, if you are intending to flip it and even hold it for over 1 year, its still a flip.

Knowing that, you can only 1031 investment property which it looks like you understand.

I have no idea what hainvg LLC's has to do with qualifying for anything on your post.

i wouldn't let the "tax consequences" drive your business decision.  What is the "best use" of the property / your funds / your time?  For example, for want of saving x% in tax, you have to spend add'tl time being a landlord and have your funds tied up.  Would it be better to sell quickly, recoup your funds and do another deal?

Good luck.

[Bruce D. Kowal]

Quote from @Karen Bolyard:

Hello everyone,

I recently purchased a SFR as an investment property and started rehab this week. Trying to decide whether to flip or rent. I had originally thought I would rent for year and do a 1031 to avoid cap gains tax, but I was told since I am a real estate professional ( I am a broker), I would be exempt from cap gains. I had also heard I need to have several homes in an LLC to qualify. We have 4 SFR's- 2 in one LLC, 1 in a different LLC and 4th is my personal residence not in an LLC. Any advice / suggestions is greatly appreciated!!

 Presumably someone has been preparing your tax returns for the past few years.  You already have investment properties.  What does your tax preparer say?

[Michael Smythe]

@Karen Bolyard didn't they test you on this stuff to get your real estate broker's license?

The only other tax issue not covered is how long you need to hold an asset before selling it to have the profit considered capital gains versus ordinary income.

Check with a tax professional on all this.

[Michael Plaks]

Quote from @Karen Bolyard:

I recently purchased a SFR as an investment property and started rehab this week. Trying to decide whether to flip or rent. I had originally thought I would rent for year and do a 1031 to avoid cap gains tax, but I was told since I am a real estate professional ( I am a broker), I would be exempt from cap gains. I had also heard I need to have several homes in an LLC to qualify. We have 4 SFR's- 2 in one LLC, 1 in a different LLC and 4th is my personal residence not in an LLC. Any advice / suggestions is greatly appreciated!!

My first advice/suggestion is to stop getting tax advice from anybody except experienced tax professionals. Otherwise it is similar to me saying "I've been told that since I'm an accountant I would be exempt from paying Realtor commissions."

Quick general pointers, as already mentioned on this thread:
- holding a flip property for a year changes nothing for taxes, in most cases
- flip properties are not taxed as capital gain taxes and are not eligible for 1031s, in most cases
- if you're a full-time broker and do not have other jobs, you will most likely qualify as a real estate professional
- which does not exempt you from any taxes, but it can create other tax benefits, specifically allow you to apply losses from your rentals against your broker income
- and there are other tax strategies that can help you

From this point, you need to get yourself a tax pro. I don't have to tell you why FSBOs don't work, right?