Avoiding capital gains through buying rentals?

[Josh Gregory]

I buy and flip houses as well as by rentals throughout the year. Currently, I am set up under two separate LLCs for protecting my rentals in case I get sued over a flip. However, I have been thinking… If I flip houses and make, say $80,000, and I also buy new rentals for $80,000 would my capital gains be wiped out because of the expense of the new rentals?

[Brandon Hall]

@Josh Gregory

Do not combine rentals and flips into one entity. The liability protection you mentioned would be wiped, and tax consequences could be severe. The problem is with the dreaded "dealer" status. While "dealer" is determined on a property-by-property basis, if you combine rentals with flips, the IRS may say that you are a dealer and classify all of your properties as inventory. This would cause your rental income to be subject to self-employment tax, and the burden of proof is now on you to prove that your intent for those rentals was investment oriented. 

It's a headache, keep businesses with different operations in different entities. 

For your capital gains question - when flipping a property, the profits will not be subject to capital gains, because that property will be considered inventory (dealer status) and inventory cannot have capital gains. Instead, the profits will be classified as active income subject to 15.3% self-employment tax. To minimize this tax liability, you will want to consider electing sub-chapter S (S-Corp) for the LLC engaged in flipping properties. An S-Corp provides you with the flexibility of classifying some of the gains on a flip as wages and the remainder of the gains as distributions. Distributions are not subject to the SE tax.

To further expand on rolling over capital gains - when you buy a new property, it's considered transferring assets into a "new account" meaning it's not considered an expense. So if you had an $80k capital gain and used those gains to buy an $80k property, the IRS looks at it as if you have moved assets from account A to account B. It's the same logic that applies to transferring money from your savings account to your checking account - it's not a taxable transaction and not deductible. 

The way to avoid capital gains is to utilize a 1031 exchange, however flips are specifically excluded from 1031 exchanges.