1031 “like type” question

General Real Estate Investing
1

I’m a bit confused about the 1031 “like type” real property exchange. Can anyone tell me if it’s legal, under the 1031 exchange rules, to sell the home I live in (relinquished property) and buy two other homes that are of less value individually (but have a greater combined value than the relinquished property) AND one of those new properties would be a rental (I would live in the other)?

Rough Numbers:

Sale price of relinquished personal home ~ $320K (~$80K equity)
1031 Exchange Home #1 (that I would live in) ~ $200K
1031 Exchange Home #2 (that I would rent out) ~ $150K

Is there an issue regarding the rental property vs the relinquished, owner occupied, property that would disqualify the deal as being unlike?

If it is allowed, can I apply the equity from the relinquished property anyway I want for tax purposes (i.e., would the only allowed tax deferment be on the owner occupied house of the exchange)?

Thank in advance!

2

You said it’s a home you live in??

If you lived there for 2 or more of the last five years, and if the GAIN is less than $250K for a single pereson, and $500K for a couple, you sell it free of capital gains tax. Then reinvest the funds.

1031’s are for investment properties which this is not.

3

No, I’ve only owned it for 15-months and I didn’t realize the relinquished propery HAD to be an investment property if the new exchange was an investment property - I was trying to figure out a way to invest the equity at the lowest possible cost. I’ll probably just stick to my “Plan A” (refi to make improvements/raise value and sell after 2-yrs).

Thanks for your input Frank!!!

4

I was thinking the same, was waiting for someone else to chime in as I wasn’t 100% on the 1031 since it was owner occ. Good post Frank.

5

One way to do this is for you to lease option the houses you plan to buy, and excercise your option, within the first year. The big benefit here is that you don’t have to identify the properties later as it has already been identified.

This will get you past the “2 year” point.

At the point of excercise, you can do a “simultaneous 3 way exchange” rather than a “deferred non simultaneous 1031 exchange thru an intermediary”. You don’t need an intermediary for simultaneous exchanges, though you might need services of a facilitator to walk the attornies and title companies throuh a slightly more complicated closing.

6

Frank,

I’m not sure about the “simultaneous 3 way exchange” – do you mean a three-way closing that would involve exercising my purchase options on the two new properties while closing the sale on my current home (after the 2-yr mark)? Sounds very interesting!

I think you’re right about the need for a “facilitator” though – I’ve had very difficult times just doing Double Closings with the Title companies around here. About a year ago, the Title Company actually told me “You can’t do that – it’s illegal!” Ha Ha

One thing that may give me a problem is the typical cost associated with lease option agreements and getting desirable properties (sale price and holding costs are typically more than I like to spend and lease op deals are often hard to convince the Seller to do, which limits the choices). I’m definitely going to look into it though – maybe there is a seller out there willing to work the numbers the way I need them to be.

Thank you again for the tip!

7

garypettee,

Don’t lose sight of the primary message in this thread – Your primary residence is NOT eligible to participate in a 1031 exchange. If you convert your primary residence to an investment property, then, it becomes eligible to participate in a 1031 exchange.

The secondary message in this thread is that you don’t want to convert your primary residence to an investment property just to DEFER capital gains taxes with an exchange when you can fully EXCLUDE your sale profits from capital gains taxes if you meet the two year primary residence ownership and occupancy tests.

Remember, an exchange does not avoid capital gains taxes, just postpones the date that the taxes have to be paid. Special rules related to the sale of a primary residence allow you to take up to $250K in sale profit (per taxpayer) tax free. You don’t tell us that you have some compelling reason to sell your primary residence. Converting it to an investment property (e.g. “selling” it on lease option), will make it eligible to participate in a 1031 exchange, but it will deny you the tax free profit available on the sale of your primary residence if you vacate the property before you have occupied it as your primary residence at least two years of the five years prior to the sale. Given the choice, you want tax free profit rather than a tax deferred profit.

Frank left quite a few details out of his exchange scenario. Let me clarify. Let’s say that B wants to exchange his property. A wants B’s property but does not have any property that B wants. C has property that B wants, but C will only exchange his property for the property that A has. Solve the problem by serial exchanges. A and B exchange their property in a direct exchange. A gets the property he wants, B gets the property that C wants. Now, B and C exchange their property in another direct exchange. As a result, B gets the property he wants, and C gets the property that B got from his exchange with A. All parties have participated in a 1031 exchange where no qualified intermediary is required and no identification period rules apply.

If this transaction is not completed with a chain of direct exchanges, then, I see the transaction as a three-party delayed exchange that would still require a qualified intermediary (even if the intermediary is the title company). Because the sale of the relinquished property and the acquisition of the replacement property are completed simultaneously, formal identification is not required because the exchange would be closed before the 45 day identification period expires.

8

Gary:

Just a few words about tax free exchanges, though it wouldn’t apply in your case, as it’s your own home. If you need to know the specifics on these issues, read up IRS sections 1031 (tax free business property) , 1032, 1033 (involuntary conversions), and 1034 (your home)

In a “non simultaneous exchange”, the type of 1031 exchanges we talk about most often, the funds of the relinguished sold property is held in trust. by the intermediary, in one closing. Then, upon the purchase of the "upleg property, the intermediary funds the purchase, at a later separate closing. The key is at no time do you touch the funds.

Then you have to follow the rules, 45 days for identification, and 180 days to close, with addiiional rules relative to cutoff based on the “tax year”.

But, if you found a buyer for your property, and you then find a property to buy, you can arrange one closing, thus a simultaneous exchange, where the buyer of your property, thru the title company, fund the purchase of your “upleg” property, at one closing, pretty much like a simultaneous closing for a flip. So, you got yourself, the buyer of your relinguished property, plus the seller of the upleg property (three parties) all together in one closing, Technically, if you’re buying TWO properties, it’s a “four way” transaction".

The simplicity here is there is no deadlines for identifiaction, closing, tax years etc. Make sure none of the funds are routed to you, but thru the title company, or attorney, acting as the intermediary.

Then, there are also 2-way exchanges, such as two farmers directly exchanging different plots of land on adjoining properties.

There’s also “reverse” 1031 exchanges, where you buy the replacement property first, providing you have funds to do so. Here also, expenses are even higher, as the intermediary has to form a separate shell entity to hold title.

Some people doing this convince buyers and sellers to long closing date, such as six to nine months, or even more. Again, it’ the difficulty of making people waiting this long.

One guy I know convinced a buyer who badly needed to buy his property to agree to a 9 to 12 month closing date, so he can locate the upleg property to invest the funds into, and upon finding it, do a simultaneous 3-way exchange. Ths way, he’s not hemmed in by a 45 day identification time frame.

The whole excercise depends on the expense of each option, and how badly the buyers and sellers want to do things.

Of course, the cheapest way, and the only way since this is your own home, is to just wait it out, 9 more months.

There are ways to shorten the 2 year required period to sell the home tax free, such as illness, change or loss of job, divorce etc. You might want to check these angles as well, if it applies to you.

9

DaveT,

I bought the property with the intentions of reselling it after a year or two and rolling the profits into something else.

There’s a little confusion regarding the “lease option” topic (probably on my part) in that I’m NOT proposing to convert my current home to an income property via a lease option. I was thinking of buying the OTHER two homes on a lease option and set up a three way closing (with the future buyer of my current home, the seller of the investment/rental home, and the seller of the second home that I would move into) after my two years is up on the home I currently live in. Then (at the closing) use my tax free profits from the sale of the home I currently occupy to satisfy the purchase option agreements on the other two homes.

I think this is what you were suggesting Frank?

Based on your last two posts, I must admit I have some serious studying to do. I apologize for the extra hoops you guys have had to jump through because of my lack of knowledge in this area.

I sure am gratefull for help and direction!

10

Yes.

I was suggesting that you tie up the two properties you want to go into via lease option, then wait 9 plus months, and sell your own home. Or if you rent out your own home in the meantime, but for a period of time, you’ll be able to do a 1031, since it’ll be an investment property qualifying for 1031. BUT in this case, the tax is only deferred, so it’s actually better to sell a home tax free overall. But if you’re taking the money out tax free selling your home, no need to do the 3 or 4 way simultaneous closing.

You’ll have to think about the market risks though. Are home prices going down?? Is the money you’re saving on taxes offset by the drop in prices??

But I like the idea of waiting 9 months the best, sell your home then, and then buy something. Simpler, and smaller risk.

11

Gary,

In 1997, Congress repealed Section 1034 (equal or up home rollover replacement rule) and the Section 121 over age-55 $125K one-time exclusion rule and passed a new Section 121 capital gains exclusion rule.

It is this new Section 121 that prescribes the two year ownership and occupancy tests to qualify for the capital gain exclusion on the sale of your primary residence.

If you proceed with your strategy, you can sell your own home now and acquire a replacement home and another investment property as well, BUT, the sale of your home will be a taxable event and capital gains taxes will apply to your sale profit. 1031 exchange tax treatment is prohibited whenever your primary residence is the relinquished property or the replacement property in your proposed exchange.

If you have a lot of profit to shelter from taxes, best to continue occupying your primary residence until you meet the two year tests. Then sell for tax free profit up to $250K per taxpayer.

12

Yes, I think it makes good sense to hold off on the sale of my home until the 2-yr plus a day mark. I can also utilize this time to bring the property up to another value level based on Comps I’ve been looking at lately - should add another $40K to $60K for a cost of $28K.

In the mean time I’m also looking for a couple of lease option deals where I can put renters in to cover the carrying costs until I’m ready to sell my place.

All should end up very good thanks to the great help I’ve gotten from you people.

Any suggestions on how to handle ownership on the two new properties? The one that will remain an income property will be leased/purchased and held in my LLC but I’m not sure how to handle the one that I will wind up living in. Can I own it in the LLCs name and lease or sell it back to myself without causing big problems by mixing personal with LLC business?

13

For my own home, I would own it personally for a number of reasons:

  • First. the rates for “owner occupied” homes are much lower, compared to those of LLC’s, at commercial rates.

  • One of the bigger risks is workman’s comp, that is, if you use an “uninsured” worker doing maintenance and repairs. Here in NY State, you are personally responsible, LLC or not, if an uninsured worker is injured, and the LLC has no workman’s comp coverage. You just can’t go out and buy a “workman’s comp” policy. On the other hand, state law requires inclusion of workman’s comp in “homeowner” type policies, not available to homes held in an LLC.

  • I am not certain how the law treats LLC held properties for homestead, and estate purposes. You’re most likely better off holding in your own name.

  • An LLC does little for you if the property is held in an LLC, and YOU are the MANAGER, and you still get sued personally. Better way, if you are married, is to hold the home in the name of one spouse, and the rental in the name of the other. So if “Mr. Owner” has tiltle to the home, and “Mrs. owner” has title to the rental, and a workman’s comp or other lawsuit results in a major loss on the rental, Mr. owner’s home is not at risk.

14

There is no homestead for an LLC.

15

Yes, I see what you mean. And, there are second home finance rates that are pretty descent from what I’ve seen. Beyond that (personally held 3rd 4th … investment properties) the interest rates are the same as what a business pays.

The LLC entity, in general, keeps demonstrating little value when it comes to the type of deals I want to do (buy/fix/flip, buy/fix/hold, tax lien certs., etc). I’m beginning to think it was a mistake setting it up in the first place - except for the aspect of establishing a separate credit profile and some operating tax write offs (that are almost completely offset by general operating expenses and …).

There’s gotta be a better way that offers true asset protection, investment flexibility, tax shelters/write offs, and favorable financing. I guess I’ll do some more studying on Trusts and other entity structuring. Ideally, my wife and I do not want to own much of anything directly – we’d rather control and use the investments then own them. In 20 or 30-yrs we’re going to give it all to kids anyway.

Sorry, I’m getting a little off track here.

Thanks again for your thoughts!

16

If you don’t want your primary residence in your own name talk with your attorney about a revocable trust, or, a Qualified Personal Residence Trust.