Avoiding capital gains through buying rentals?

Question

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 · Answer

@Josh GregoryDo 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.

Jesse T. · Answer

Flips are taxed as normal income.If you buy a property, improve it and rent out for a reasonable period - you roll the proceeds of the sale into a 1031exchange. The 1031 is a tax deferral of capital gains and depreciation recapture.

Zachary Bohn · Answer

@Mike H. The other thing is that since you can buy multiple properties as replacement property, you can always have a partial 1031 and only pay the tax on the cash you end up receiving. You just have to have the mindset that you will still only buy properties that meet your criteria or pay the taxes

Dave Foster · Answer

@Mike H., In the situation of the OP several years ago they had set up their business entity very well to be able to separate their two lines of business - flipping and buy and hold, @Zachary Bohn and @Kory Reynolds are right on the money with their explanations of how those two operations are still treated differently but can be combined on one tax return. However, there is another reason (probably) why the OP chose to set up his business lines as two ventures. The traditional way to defer tax and depreciation recapture when selling and buying investment real estate (the buy and hold side) is to utilize the 1031 exchange. The 1031 is for real estate you own with the intent of holding for productive use. So, as mentioned earlier, the 1031 does not apply to fix n flips. There is no statutory holding period or qualifying standard other than your intent to hold and how you can demonstrate that intent. So for that reason a lot of folks like you and the OP will choose to create two business presences. One that fix's n flips, and one that buys and holds. By simply doing this the owner is saying that the properties owned in his buy and hold entity have been purchased with that intent and qualify for 1031 treatment. It's not bullet proof. But it's a good step on the way to demonstrating your intent to hold. It also let's you think about classifying your outlays so that as much as possible you are capitalizing expenses on the buy and hold side where passive limitations exist and where increasing depreciable basis is important. The opposite is true of course in a fix n flip business where your current expenses (cost of goods, etc) have an immediate impact on your profit and subsequent taxability.The answer to your dilemma of depreciation recapture is to use the 1031 on the buy and hold side. build tax advantaged equity with that by indefinitely deferring all tax on gain and depreciation recap. The fix n flip side becomes cash flow. You're going to pay tax but you can mitigate that somewhat and there won't be significant depreciation recap.

Zachary Bohn · Answer

@Mike H. when you sell a property there isn't really a way to only pay capital gains tax and avoid recapture. You pretty much have to bite the bullet, unless there is some reasoning behind allocating a larger sale price to the land portion. There are still requirements that you have to hit to qualify as a real estate professional according to the IRS, and you want to make sure you evaluate all of the criteria since this is generally an area that gets people audited. You also need to look at the implication of becoming a real estate professional. That is only half the battle. Then you have to have material participation in an activity to not be subject to the limitations. If you have to make a grouping election to satisfy the material participation test, then that can impact your ability to deduct the suspended losses. If you have suspended losses now and then the activities become nonpassive the suspended losses can only offset the current year income from that activity and the remainder is treated as suspended losses still.

Kory Reynolds · Answer

Great post, I agree with everything, just wanted to offer a couple more considerations in these areas.For the dealer status, since it is a property by property consideration, I wouldn't worry about it too much if it is all in the same LLC. If you are audited for that consideration - likely they'll look at all your holdings and not just a blinder to that one entity, especially since it is a SE tax consideration. You'll have the precedent set in Pritchett v. Commissioner, 63 T.C. 149 (1974) on your side that it is a property by property consideration, and as long as your ducks are in a row you'd be good. We talk through this issue with a number of clients who are developers and hold rentals, with good record keeping and the correct intent one should be golden.For the S-Corp consideration, you would want to very carefully consider 199A. For example if reasonable comp for your S-Corp is approaching the FICA wage base, your S-Corp status could cost more in loss of 199A then it saved you in self employment. Of course if income is high enough you need to be at the balance where you have enough w2 wages to support the deduction. Definitely a client by client consideration to weigh all of the factors involved, it isn't as easy of a decision as it used to be!

Rob Beland · Answer

Sorry @Josh Gregoryyou can't 1031 a property you purchased to flip. The property must have been purchased and held for investment. One thing you might consider is looking at an S-Corp vs. an LLC for your house flipping business. You'll save on self-employment tax by paying yourself a salary and taking the rest of the profit as a distribution.

Dave Foster · Answer

@Mike H. Very thoughtful post. I know that lady (well actually I know people like that lady) . But her undisciplined approach doesn't have to taint the product. What's the meme - Hate the playa not the game :)Couple of things...1. You're absolutely right about the indefinite deferral. That's exactly like a regular retirement account as well. But no one complains that those are only deferral. But 1031 actually has better terms than your normal IRA - there is no required minimum distribution. So you literally can defer the tax, using it for your own benefit, until you die at which point the tax disappears for your heirs. Before that you can also purchase a property that may end up being a new primary residence for you using a 1031. After you've used that property for a while as investment you can convert it to your new primary and sell your old primary - voila!! Tax free money once again.2. But there's the biggest surprise for you and a lot of people. 1031s are not expensive. In your example you'd be saving $13K of taxes. that exchange would run you from $750 - $1000. So for a chance to save $13K you spend $750. That doesn't seem to be such a bad deal.3. There's no penalty for starting a 1031 and not completing it . You are simply out the exchange fee. This is why your story distresses me but it doesn't have to be your story. That lady was foolhardy to purchase those properties the way she did and with the motivation she had. She could have simply let the exchange die and pay the tax. But the $750 if what kept her options alive. Not a bad trade off.4. Yep the timelines can feel tight. But it truly is more perceptual than actual. Of course if you're just starting to explore an area after you've closed your sale then you should feel a bit of heat. That's not a wise plan. But if you know where you want to invest you can spend months or years getting to know it. And if you find something you like you can always go into contract for the purchase prior to closing the sale. So reasonably what feels like a month and a half to find a new property easily becomes 3-5 months. Again, that's not such a touch situation to navigate around.

Mike H. · Answer

Here's the trick with 1031 that I can see - at least when it comes to using it with sfh investing. One is that is just defers the tax - hopefully forever and then its free money. But there's also costs associated with it as well. Lets say I were to sell a house and get 30k in recaptured depreciation and 30k in long term capital gain. My taxes would be what, 12k or 13k? But what would the costs of having that entity manage the 1031 as part of the process? Secondly, there is the issue of significant restrictions on being able to identify the property you're rolling the profit of the sale into. I just witnessed someone from california come to this area and struggle to try to get her money reinvested before the clock struck 12. It was to the point where she was paying retail just to do it.She bought an apt building that chewed up a big chunk and then bought a 120k house that was worth 120k just to use it all up to avoid taxes. But while she avoided taxes, she paid retail. To me, that was a wash. I think i would have rather paid the 25k or 30k in taxes now and waited til I found a real deal where I would be all in on a 120k house for 85k. And now I'd have no carry over depreciation on the new house so I would have more to depreciate. Wouldn't I?I guess thats the thing that would worry me with a 1031. That crazy deadline to reinvest in a short window OR ELSE. :-)

Zachary Bohn · Answer

@Mike H. unfortunately no that isn't how it works. When passive losses are freed up they just become an ordinary deduction, you can't choose where it offsets directly. But that means you'll get an ordinary deduction instead of lowering income that could be taxed at beneficial rates. The rate for unrecaptured 1250 gain is a max of 25%, but depending on other income can still be taxed at lower rates.