Complicated "?" regarding developing & family tax law.

General Real Estate Investing
1

Hello,

First, thank you to everyone who reads this and particularly to anyone who replies to this with advice. I’ll try to make it clear and brief.

Question: What would you do if presented with the following situation, assuming that you were 26 years old, single, have no real property assets, and not adverse to sweat equity?

Motive: I want to buy property owned by my father and stepmother in order to develop the land and hold a 4 family rental unit.

Situation: Dad is getting divorced from stepmom. Dad owns 50% of the property. Everyone is on nice terms, and stepmom wants to cash out. She wants me to buy her out in private sale. Dad is eager in any way to ‘give’ me his share of the real property. State is Maine.

Details:

Total paid amount for property 5 yrs ago: $250,000

Property includes the following three “entities”:
(A) one 4-unit renovated farmhouse w/ horse barn and 8+ acre horse pasture land;
(C) four house lots that can be sold or developed:
(B) one adjacent lot that stepmom owns completly free and clear, and of which she owns 100%. This is not part of the property that the original $250,000 paid for.

Gross monthly rental income for the 4-unit farmhouse: $3,100

Taxes: $5,000

Current debt on property: one owner-financed mortgage at 5% with $185,000/15-out-of-twenty years remaining, and one higher interest loan at 7% with $50,000/10-out-of-fifteen years remaining. Current total payment for both is $1,600.

Fair market value of the three entities:
(A) 4-unit farmhouse: $450,000;
(B) Four house lots: $90,000 each;
(C) Step-mom’s lot: $90,000 (remember my dad does not own any of this).

So… my dad’s wants to ‘give’ me his share (bear in mind that his interest in this property represents all of his net worth), so that with it I can buy out my step-mom (including her 50% interest as well as her fully owned lot) and own the entire three entities. I would then develop the five lots. Building a house on each of the four-included-lots and selling them will result in a net profit of approximately $185,000/lot (this includes building and closing costs, but assumes no cost to me for the lots themsleves). For the fifth lot that my step-mom owns, the net profit would be approximately $95,000 because my step-mom would probably demand that I pay market value, or, $90,000 for it.

Issues/possibilities:

a) dad will pay capital gains if he “gives” me his 50%…
b) IRS will not let my Dad give me his 50%…
c) I (and/or my dad) can live in one of the units of the 4-unit farmhouse…
d) 1031 exchange…
e) $250,000 profit tax exemption if living in house for 2+ years (this would apply to developing the houses: if i were to live in one for 2 years before selling and moving to the next)…
f) commercial depreciation…
g) LLC or C/S corp. creation…

What specifically is the best way for my dad to ‘give’ me his 50% share (including his shear of mortgage debt)? It as been recommeded to me that I just buy out my step-mom and become a partner with my dad in order to avoid tax losses for me or my dad. If this is the best scenario, is there any way for my to take all ownership after that (or over time) without tax consequences?

In conclusion, I basically want to make money as quickly as possible by developing the lots, pay as little taxes as possible, and return more money to my dad than if he were to sell his share now without developing the lots. As a last note, much of the money I will return to my dad could be in the form of a house or vacation house.

Whew…

THANK YOU.

Eli

PS: please ask for more details/clarification if you want them!

2

Sorry for not including the following about how the heck I can afford this:

A) I have about $70,000 cash to invest in this project.
B) The original financer of the 5% loan will gladly allow me to take over the loan.
C) I can get outside investors if I HAVE to.

Questions regarding these issues:

What’s the best way to get a loan to buy my step-mom’s 50% as well as her seperatly owned lot?

Will the greatly appreciated equity of my dad’s share help my borrowing power if he co-signs or somehow gives it to me?

What is the best way to finance each of the 5 house developments?

THANKS.

Eli

3

you’ve covered a lot of ground here. maybe too much to cover in a forum. so let’s break it down.

the IRS won’t stop dad from giving you the property, but he may have to file a gift tax return. he can give away a million lifetime tax free, but going over the annual limit in a single year triggers thh return. no problem with it, just a hassle.

He gifts it to you at his basis (cost); any gains will be yours alone.

If you buy it below market, he may realize some gain and some gift. Your basis will be the purchase price plus the value of the gift. (I think – I’m working off the cuff here --Dave, this sound right?)

you buy for 50% of market, they gift you 50%. You assume mortgage. Step-mom carries a 2nd mortgage on the purchased half, which she keeps in the divorce. Thus she is assured of getting her half of the investment value. ($800k value minus mortgages of 235 = 565 cash they would realize on a sale. dad gives you half, you buy mom’s half for 283 is one way to split it)

you should do a seperate deal for step-mom’s 100% property. typical buy/sell transaction. see if she’ll carry a sweet mortgage for you.

Everyone needs to make sure that the subject property is addressed in the divorce decree. Preferably you’d get it under contract prior, and the split of the sale would be addressed by the decree. Put EVERYTHING IN WRITING. What is all happy and “getting along” now could be a backstabbing, phycho nightmare next week.

you can live there. so can dad.

you should consider you and dad becoming tenants, especially if you do the deal in an entity. this avoids comingling plus give you better rent rolls & ratios.

with that much equity in the deal, you shouldn’t have trouble getting a loan.

4

first off, thanks for sharing this scenario. its pretty interesting.

building upon what mcwagner said, I would find out how much the step-mom is willing carryback (this is the key piece of missing info in my mind) and get her to agree to some type of balloon payment so that you can make payments on her 2nd as you sell off the lots (and not be burning cash every month).

as for lending, it could be a little bit tricky depending on how the separate building lots are deeded. Some lenders might be a bit funny about having raw land tacked to the deal if the 4 unit building does not emcumber it or appear on the same deed. of course, it might be common in your area and then know how to handle it.

for her lot she owns 100%, try and get as much carryback as possible, but do it as a separate deal.

this looks like a pretty sweet deal; definately need an entity and a good atty/title company to handle the paperwork. Document like crazy!

5

I believe the buyer’s basis in this case is the amount paid plus that portion of the gift of equity for which gift tax is paid by the giver.

6

but there’d be no actual gift tax (just a gift tax return) as long as the gift stayed under the giver’s $1mil lifetime allowable threshold.

7

Then the basis would be what the buyer actually paid. The value of the gift of equity is tax free to the recipient. The IRS gets its due when the property is sold and the value of the gift is included in the seller’s taxable capital gain.

If gift taxes had been paid on a portion of the gift, then that portion is added to basis and not taxed again when the property is later sold in a taxable event.

8

Thanks to all who have read my post and especially to those who have replied with their insight. I’ve broken down a few questions - forgive me if I’m asking for too much free consulting / stupid questions…

Thanks mcwagner… you wrote:

“you buy for 50% of market, they gift you 50%. You assume mortgage. Step-mom carries a 2nd mortgage on the purchased half, which she keeps in the divorce. Thus she is assured of getting her half of the investment value. ($800k value minus mortgages of 235 = 565 cash they would realize on a sale. dad gives you half, you buy mom’s half for 283 is one way to split it)”

Step-mom will not hold a mortgage for me - she wants to cash out. I’m not sure that I understand how she can make her profit if she sells me only half of her share and gifts me the other half. Wouldn’t that mean she would only get half of her 50% share of the profit?

“Everyone needs to make sure that the subject property is addressed in the divorce decree. Preferably you’d get it under contract prior, and the split of the sale would be addressed by the decree. Put EVERYTHING IN WRITING.”

Are you saying that you recommend that they sell and gift it to me jointly while they are still married (as opposed to after they become divorced), and then address splitting the profits between them within the divorce decree? My step-mom will want to cash out completely, and won’t be interested in carrying any mortgages for me.

“you can live there. so can dad.

you should consider you and dad becoming tenants, especially if you do the deal in an entity. this avoids comingling plus give you better rent rolls & ratios.”

a) How would that avoid comingling?
b) Is there an advantage to one of us living there instead of two?
c) Could you explain what you mean by “better rent rolls and ratios”?
d) Also, the idea is that my dad will give me everthing of his share, leaving him with zero ownership. Does your point above assume that it is not possible or beneficial for my dad to gift me his complete share of the property, but rather that we remain tenants in common or something?

Thanks aak5454… you wrote:

“definately need an entity and a good atty/title company to handle the paperwork. Document like crazy!”

For an entity, will an LLC be the best? Also, I am a true believer in a good atty/tittle company. I will also be buying a copy machine for all of the papers!

In conclusion,

I am meeting with both of them and a accountant next week. This conversation has helped me understand a bit of what I might expect as well as what questions I should address. Are ther any other ideas that I might want to discuss with the accountant?

And lastly, when it comes to developing the lots, do any of the various procedures affect my ability to sell by way of a 1031 exchange or the $250,000 profit tax exemption if living in a house for 2+ years? I am worried that I will not neccessarily be able to take advantage of those benefits when developing the lots if I still own the 4-unit farmhouse (which I want to hold and use as a refi springboard).

Thanks again!

Eli

9

you can buy it for whatever all the parties agree to.

in theory, dad owns half. stepmom owns half. there’s a mortgage, which will reduce any cash-in-the-pocket if they sell. step mom would only be entitled to half of that cash.

thus: 800 value minus 235 mortgages = 565 they would stand to cash out together. mom is entitled to half of this amount (minus selling expenses, etc) or 283

you buy for 283 + 235 = 518. the difference between that and 800 is your dad’s half of the profit that he “gave” you.

if they divorce first, the property has to be dealt with in the divorce. If they sell first, the property is already disposed and does not have to be dealt with in the divorce. Plus, if the divorce goes bad, you’ve already got the property before everybody gets pissed off at each other. IMO it’s just easier to sell first.

If an entity owns the property, you face comingling issues if you live there rent-free. You don’t own the property! If you and dad want to live there, be a tenant of the entity, which owns the property. sign a lease, pay rent, the whole deal.

the entity also benefits by your being a tenant; the rent rolls are higher, giving the entity better income/debt ratios.

LLC all the way.

10

mcwagner, THANKS! That was a very clear explanation of what I was confused about… I think you would be better suited to writing a real estate book than many of the authors I have read recently.

I have had a suprisingly difficult time finding the answer to this one question by reading through books and various online forums: If I build a house and sell it, will it qualify for a 1031 exchange? I know that flipped homes do not, so I assume that the answer here is no.

If that is the case, what are my best options to avoid paying taxes when building and selling a home? Would it be one of the following: either, a) live in it for two years then sell, or b) rent it for a year then sell as a 1031 exchange…? Would long term capital gains come into play if niether of these worked out?

Thanks again everyone. Upon this message I vow to bow out from my display of excessive questioning during this thread!

Eli

11

Don’t be afraid to ask the tough questions. That is what the forums are for. I learned a lot just by reading the answers to your questions.

Thanks to all the vets for thier responses, btw.

~joshua

12

Joshua,

Thanks for the reply. I try to be clear so that everyone (including me) can grasp what the issues are, and maybe even learn something new or even contribute to the discussion for the benefit of those of us who still have alot to learn. I’m glad you took interest in the posts.

On a different note, I am always looking for good and informative reads. FWIW, I recommend Investing in Duplexes, Triplexs & Quads: The Fastest and Safest Way to Real Estate Wealth, Larry B Loftis. Although not extremely detailed, it really gave me a clear idea of what I should be concentrating on and how I should be evaluating real estate investments. I’m pretty novice, however, so don’t take my word to the bank. I read it just before posting to this board.

Does anyone else have any great reads to recommend?

13

building and selling homes as a business is not eligible for 1031 treatment. the houses are not “investment” property; they are inventory. ordinary income plus SE tax.

If you do it inside an LLC taxed as a C-corp, and take a salary, you will probably enjoy a lower total tax bill if you plan to keep most of the money in the company.

LLC taxed as S-corp, if you do it right, would be the next choice.

depends on your specific plans for the income.