Capital Gains Avoidance
Well I just put a contract in on my first rehab project and was told after I sell the property I would have sixty days to reinvest the money in another investment property or have to pay short term capital gains taxes (mind you this information did not come from a CPA). I have several questions:
1. Is this true?
2. If not true, how long do I have to invest the money and in what other avenues could I invest the money?
3. Do you have to leave the money in a property for a year before it becomes long term capital gains or just use the money for investing purposes for a year? ie sell house a 1/1 and make 25k, can I keep investing the same 25k in a house each month sell it and then after a year the 25k becomes long term or must it remain in one property for a year to become long term capital gains? 
1, NO.
2. Your profit on the sale of your rehab property is fully taxable as ordinary income in the year of the sale. You do not defer taxes by rolling over your profit into another rehab project. Because you are engaged in an active business, your profits are ordinary income and the capital gains holding period rules do not apply. Also, your property is not eligible to participate in a 1031 tax deferred exchange.
3. If you are in a rehab business, then you want to keep turning over your inventory because you do not recover your investment and make a profit until you sell the property. Even if you took one year to rehab a property then sold it one month later, your profit is still ordinary income regardless of your holding period.
Property flipping in all its forms (contract assignment, wholesale flips, rehab and retail flip, sandwich lease option, Subject To and sell on Contract for Deed, etc) is an active income business. Active income is fully taxable when the property is sold regardless of how you choose to reinvest your profits.
DaveT:
Why wouldn't this property qualify for a 1031 exchange? What are the rules regarding the 1031 exchange and what kind of deals it pertains to. Can you enlighten us about this???
You are very helpful!
Thanks!
Matt
Thanks Dave,
Like I said, the guy wasn't a CPA, he just stayed at a Holiday Inn Express.
Quote:Why wouldn't this property qualify for a 1031 exchange? What are the rules regarding the 1031 exchange and what kind of deals it pertains to.Property flipping in all its forms (contract assignment, wholesale flips, rehab and retail flip, sandwich lease option, Subject To and sell on Contract for Deed, etc) is an active income business.
The inventory being bought and sold in this active income business happens to be real estate, but it is still inventory (or stock in trade) to the business. Just like the grocery store, the furniture store, or the hardware store, when you sell your inventory at a profit, your profit is ordinary income to your business.
The 1031 exchange rules prohibit using inventory, stock in trade, or even your personal residence at either end of the exchange. Instead, the exchange rules that apply to us as real estate investors, limit qualifying property to real estate held for a qualified "investment" use. The IRS defines property held for a qualified investment use as property used for the production of income (rental property, for example) or held for long term appreciation (raw land, for example). Real estate that is "inventory" to your business is not property held for a qualified investment use.
DaveT - Thanks for the clarification!
You are always here to help...
You are the man!
Matt
DaveT,
Are you a CPA or did you also stay at a Holiday Inn Express? It's like you wrote the tax code. God I love this site.
Is there any way to hide the fact that you are flipping properties (ie. make them appear as properties, not inventory)??
Or, are you saying that if you are flipping, rehabbing, assigning, etc. that there is no way to avoid CG?
So, to avoid CG as an REI, you'd have to be in the business of rentals, but you'd then still be taxed reguarly on rental income? Yet, you'd avoid CG when you sold?
I'm new to this game, just trying to get this all straight. Thanks.
You could set up a self directed IRA that purchases the property. Of course, all money earned must be put back into the IRA but it would not be taxed as income.
Quote:Is there any way to hide the fact that you are flipping properties (ie. make them appear as properties, not inventory)??Yes, it is called tax evasion. The long term consequences in my mind outweigh the short term benefits you might gain.
I have mentioned in other posts, that I have concerns about using your IRA to conduct your flip activities because I maintain that you just bring Unrelated Business Income Taxes into play.
Quote:Or, are you saying that if you are flipping, rehabbing, assigning, etc. that there is no way to avoid CG?I am saying that capital gains tax treatment does not apply. Instead, your profits from your business activities are ordinary income taxed at your ordinary income tax rate and also subject to self-employment taxes.
Quote:So, to avoid CG as an REI, you'd have to be in the business of rentals, but you'd then still be taxed reguarly on rental income? Yet, you'd avoid CG when you sold?Rental property, when sold, is still subject to capital gains taxes. There are tax deferral strategies available to investors that are not available to those engaged in an active income (business) activity
So if I had a rental and sold it after 1 year it would be an investment and capitol gains tax would apply. If I had a rental with an option and sold it after 1 year it would be a business activity and regular income taxes would apply. Does it all boil down to intent??
Brenda
Exactly.
Your pattern of activity, your predominant investment approach, aggressive marketing to "sell", and reluctance to hold long term rentals are just among some of the characteristic indicators of your intent.