Avoiding captial gains tax by lease optioning property.
If you lease optioned an undervalued property and took the equity to reinvest in income property, would this defer you capital gains on property till property is sold? 
Sorry, but you need to be a little more specific before I could begin to answer this question.
Are you buying the option, or selling the option?
Where is the cash from the equity coming from?
Perhaps if you could describe the mechanics of this transaction a little more fully, I will be able to describe your tax liability.
I want to buy a under valued property with the intention of selling in three years.
I want to take a second on the property to remove my downpayment and 10,000 to invest in more property.
During the three years i want to lease/option the property
My really want to flip the property but delaying the sale and taking equity out to reinvest would defer my capital gains taxes till the year I sell the house.
calimack,
You don't really "avoid" capital gains taxes with a lease option. Capital gains tax on your profits would be due when the property is sold, regardless of whether a lease option is used to facilitate the sale.
You have one taxable activity and two taxable events to deal with here -- a lease, the sale of the property, and the expiration of the lease option.
During the lease period, you report all rental income and expenses on Schedule E. If you net any income from your rental activities, you include this amount in your ordinary income and it is taxed at your marginal tax rate. Under certain limitations, up to $25K in passive (rental) activity losses can be used to offset other ordinary income each year.
When the property is sold, you have capital gain to deal with as well as depreciation recapture. The good news is that you may be able to purchase a replacement property with the sale proceeds and defer your capital gains taxes by using a 1031 like-kind exchange.
Lastly, when (but not until) the option to purchase expires, any option consideration you collected becomes taxable as ordinary income. Some investors just treat this option consideration as extra rent collected and report it on their Schedule E.
The "problem" you may run into here is your three year option period. What if the tenant-buyer exercised the option within the first year? You lose long term capital gain tax treatment, making all your income taxable at your marginal tax rate. To ensure that you qualify for long term capital gains, maybe you should get at least one year of straight rental use out of the property before offering a lease option to your tenants.[ Edited by DaveT on Date 02/12/2003 ]
Thank you so much, very good information
One correction to DaveT's post:
He wrote" "Lastly, when (but not until) the option to purchase expires, any option consideration you collected becomes taxable as ordinary income. Some investors just treat this option consideration as extra rent collected and report it on their Schedule E."
When the option expires without being exercised, the option consideration will be short-term capital gains (always!) not ordinary income. Although the tax rates for short-term capital gains is the same as ordinary income and will usually produce the same result, there are circumstances where the character of the income will make a big difference, especially if you have business net operating losses that you wish to try and use.
Hope that helps,
Taxjunkie