Rental Property + 1031 + Parents Retirement + Brother's Stupidity Question

[Spur08 382]

Bear with me while I set the scene.

My folks are planning on moving out of our childhood home and moving a little closer to me, my brother, and their grandkids. 

 

My brother does some real estate transactions through a LLC that he opened/owned pre-marriage.  He owns a rental property in Fort Worth that was purchased pre-marriage.  He claims that it has been maintained post-marriage by accounts within the LLC that have always been separate.  This month, he is selling the rental property for a profit.  One question I have is when, if ever, does this account or its assets become community property?  No pre-nup in their marriage.

Transition back to the folks.  My brother has convinced my parents to let him 1031 exchange the profit from the rental property into buying their home so that he can avoid paying cap gains.  After a year, my parents would then buy the property back from my brother as both my parents head into retirement.  My brother believes, at that time, he and his wife will be in a better position to open their own vet practice and wants to use that rental property money for doing just that. 

 

Personally, I have a lot of issues with this and I’m trying to educate myself on the disadvantages of this approach.  First, my brother’s [second] marriage is not a strong one.  He has mentioned to me over the weeks how he thinks he would be better off financially with a divorce.  As such, one concern I have is whether or not the home my parents will be living in will be safe/secure if my brother was to go through a divorce at that time.  Second, are there any tax disadvantages for my parents or my brother in using this approach?  It seems like an extremely convoluted and complex way to avoid paying cap gains for a year and this money is going to end up in a community property destination anyways.

[CO Horn 171]

As to the first question, if community assets were never commingled, it should remain separate property. 

A couple of things on the second. First, there are rules about related party exchanges. Not sure if this would qualify. Second, if they purchase the property back in a year, he’ll still pay the capital gains tax. 

[CO Horn 171]

http://www.exeter1031.com/1031_exchange_related_party_issues.aspx

Yep, can’t do it. See acquiring property from a related party. 

[TwiceHorn 31868]

In Texas, even absent commingling, capital growth remains separate while income from a property is community.  If you plow the income back into an investment, you have commingled, but an attempt can be made to back the income out in the event of divorce.

[Jhawk 1075]

19 hours ago, CO Horn said:

http://www.exeter1031.com/1031_exchange_related_party_issues.aspx

Yep, can’t do it. See acquiring property from a related party. 

My company engages in 1031 multiple times a year. IRS code doesn’t define “related party” as relatives. A legitimate transaction between relatives is allowed (we have done one). Related party in this case means you cannot buy a property from yourself or another company you have ownership in. 

I cannot speak at all to the divorce stuff but regarding the exchange, there are about 35 +/- rules that govern a 1031 exchange. It is important to note that these are “safe harbor” rules. For anyone to satisfy all of them their gain would basically have to be minimal and they would have to essentially buy an identical property with nearly identical debt burden. Almost no transactions satisfy all rules. When we engage in a 1031 exchange we satisfy about 8 of them. In 3 years we have received zero scrutiny because this section of the tax code hasn’t been scrutinized since it was out in place. Not under dems and not under repubs. I would consult a tax lawyer if the potential tax burden of the exchange is greater than $50k. Also, the longer the purchased property is held the less likely you are to draw scrutiny. We do have a strategic partner who has bought a property all cash and financed it within a month and not drawn scrutiny so there is flexibility depending on how risk averse you are. 

Ladtly, this fucks your patents. Why aren’t they exchanging? Seems like they would need money more given they are retiring. 

 

****please note, I am not an accountant and I am not an attorney. This post is my non legal opinion and you should seek the advice of a TAX ATTORNEY. No other professional will be able to guide you through this with the level of care needed if you are going to potentially push the limits of the safe harbor.  We have had 1031 qualified intermediaries tell us that how we play the game is against the rules. We sought legal opinions from various firms to make sure we were taking appropriate risks for our taste*****

Edited August 20, 2018 by Jhawk

[Spur08 382]

Oof, your brother sounds like a beating.

This isn't the half of it. Almost 40 year old who is the most self centered person I know. He's a pro at making his problems everyone else's problem.

In Texas, even absent commingling, capital growth remains separate while income from a property is community.  If you plow the income back into an investment, you have commingled, but an attempt can be made to back the income out in the event of divorce.

He says that all upkeep was paid via rental income that was maintained in the LLC (separate) acct

http://www.exeter1031.com/1031_exchange_related_party_issues.aspx
Yep, can’t do it. See acquiring property from a related party. 

From what I'm getting from this, it can be done as long as certain stipulations are met.

[CO Horn 171]

However, it appears that you may not be able to dispose of (sell) relinquished property to a non-related party and acquire like-kind replacement property from a related party without recognizing depreciation recapture and capital gain income tax liabilities.

I disagree with Jhawk that relatives are not related parties. Code Sec 1031(f)(3) defines related parties.  It refers to code Section 267(b) which in turn refers to 267(c)(4) that defines related persons as:

The family of an individual shall include only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants

[Spur08 382]

It sounds like my folks are claiming the one-time, over 55 rule of exemption on paying cap gains on your primary residence, so they're not worried about their 1031.  Per my dad, my brother's tax burden on his property is $20K or so and he's "clearing this" through some organization where "this is what they do"

Edited August 20, 2018 by Spur08

[Lobwedgephil 1146]

Sounds like it will be a fun 7 years hoping he doesn't get audited. 

[CO Horn 171]

23 minutes ago, Spur08 said:

It sounds like my folks are claiming the one-time, over 55 rule of exemption on paying cap gains on your primary residence, so they're not worried about their 1031.  Per my dad, my brother's tax burden on his property is $20K or so and he's "clearing this" through some organization where "this is what they do"

That rule went away 20 years ago.  The current rules is they can exclude $500K of gain if they have owned and used as personal residence for 2 of the last 5 years.  

[Spur08 382]

20 minutes ago, CO Horn said:

That rule went away 20 years ago.  The current rules is they can exclude $500K of gain if they have owned and used as personal residence for 2 of the last 5 years.  

That's the rule I meant.  Didn't realize there was a difference.  They do meet both criteria.

[CO Horn 171]

The issue is not with your parents selling the property, it is with your brother buying the property.  Even if he could do it, he would have to pay tax on the gain when he sells it back to them in a couple of years, unless he did another 1031 exchange.

[Spur08 382]

19 minutes ago, CO Horn said:

The issue is not with your parents selling the property, it is with your brother buying the property.  Even if he could do it, he would have to pay tax on the gain when he sells it back to them in a couple of years, unless he did another 1031 exchange.

Right.  Which he plans to roll into when they (him and his wife that he doesn't know if he likes) open their own vet practice.  They will, or plan to, buy a property to do this.

 

Don't get me wrong.  I am vehemently against this but, to my dad, he's just trying to help out one of his kids.  In my opinion, my brother has put himself as priority #1 during their housing transition process.  I've run out of things to throw at this deal to break it up so we'll see.  My dad tells me if the deal gets fucked and there are [IRS or other] repercussions, then it's all on my brother.

[CO Horn 171]

22 minutes ago, Spur08 said:

Right.  Which he plans to roll into when they (him and his wife that he doesn't know if he likes) open their own vet practice.  They will, or plan to, buy a property to do this.

That would probably work, but doesn't change the fact (IMO) that he can't purchase your parents' home as replacement property.

[Spur08 382]

25 minutes ago, CO Horn said:

That would probably work, but doesn't change the fact (IMO) that he can't purchase your parents' home as replacement property.

Hm..maybe we're not on the same page.

 

Folks are selling their home to someone else.  Brother is selling rental house to someone else and buying (1031) a new home for the folks.  Folks pay rent for year or whatever, then "buys" the home from brother at the remaining balance of the mortgage (dad will pay it off completely).  Brother 1031s to vet building.  From what I read in that link above, it's allowed as long as certain conditions are met.

Edited August 20, 2018 by Spur08

[CO Horn 171]

22 minutes ago, Spur08 said:

Hm..maybe we're not on the same page.

 

Folks are selling their home to someone else.  Brother is selling rental house to someone else and buying (1031) a new home for the folks.  Folks pay rent for year or whatever, then buy the home from brother.  Brother 1031s to vet building.  From what I read in that link above, it's allowed as long as certain conditions are met.

We were not. Your original posting said he was buying their home, not buying a home for them.  If he is purchasing from a 3rd party and renting to your parents at arms-length, what he is proposing should work.  When he buys the vet property, it will need to be titled in his name or whatever name is on title of the current property and lease it to the vet entity.

[Spur08 382]

My fault.  Definitely buying their new home.  So, ultimately, it sounds legit.

 

Still pisses me off though

[Jhawk 1075]

1 hour ago, CO Horn said:

However, it appears that you may not be able to dispose of (sell) relinquished property to a non-related party and acquire like-kind replacement property from a related party without recognizing depreciation recapture and capital gain income tax liabilities.

I disagree with Jhawk that relatives are not related parties. Code Sec 1031(f)(3) defines related parties.  It refers to code Section 267(b) which in turn refers to 267(c)(4) that defines related persons as:

The family of an individual shall include only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants

Once again, my non-legal opinion, as long as you a have legitimate transaction this should not matter.  If you are acquiring the property for pennies on the dollar you will definitely have a problem.  Legitimate transactions are legitimate transactions.

None of that matters though as it appears the brother wants to buy the new home.  I still think this is a dumb idea even without the marriage issues.  The parents should preserve their equity and gains on their old home by purchasing their new home.  If they need money they can place a HELOC on the property or wait 12 months and cash out refinance.  The longer you hold properties the less likely they are to draw scrutiny so even if they cash out refi, it is best to talk with a JD that holds a CPA.  If your parents have a $500k house that is 100% paid off and is sold for $700k then they are going to have about a $45-50k tax bill.  That is probably a year or more of living expenses for an old couple (depending on lifestyle).  The only person who gets any benefit in the scenario laid out is the brother and that might come at a detriment to the parents.  It sounds like the brother is trying to better himself without regard to the rest of the family.

[Spur08 382]

I agree with the bulk of your statement, especially about my brother as that is his personality.  I could bitch about that fucker for days but that's not the point of this thread.

 

Parents could buy the house in cash now.  They're selling the house for <$500K so they won't have a tax bill regardless.  But, if they needed to move again within 5 years to a home or something (not expecting that) then the cash out option would no longer be available.  

[Jhawk 1075]

21 minutes ago, Spur08 said:

I agree with the bulk of your statement, especially about my brother as that is his personality.  I could bitch about that fucker for days but that's not the point of this thread.

 

Parents could buy the house in cash now.  They're selling the house for <$500K so they won't have a tax bill regardless.  But, if they needed to move again within 5 years to a home or something (not expecting that) then the cash out option would no longer be available.  

I want to be clear, they will have a tax bill on any gain.  I was using $500k as an arbitrary number.  If they bought the house for 100k and sold it for 110k they will have a 10k gain that will be subject to 22% federal capital gains tax and then texas tax (whatever that is) on top of that.

Edited August 20, 2018 by Jhawk

[Spur08 382]

21 minutes ago, Jhawk said:

I want to be clear, they will have a tax bill on any gain.  I was using $500k as an arbitrary number.  If they bought the house for 100k and sold it for 110k they will have a 10k gain that will be subject to 22% federal capital gains tax and then texas tax (whatever that is) on top of that.

I don't believe that's correct.  This is what he will be doing to qualify for exemption: https://homeguides.sfgate.com/age-can-person-sell-house-tax-exempt-39903.html

That's just a general link but was discussed upthread.

 

[Jhawk 1075]

Ahhh.. that works then.  I work in commercial so maybe my rules are a little different.

[Reagan1k 3033]

He's doing all this to avoid a $20K tax bill?

That's insane.  Pay the tax and let the parents do their own thing.

Sounds like he is obsessed with something he read on line or got pitched and is letting the tax-tail wag everything.

[elnimo 55]

On 8/19/2018 at 9:24 AM, Spur08 said:

Transition back to the folks.  My brother has convinced my parents to let him 1031 exchange the profit from the rental property into buying their home so that he can avoid paying cap gains.  After a year, my parents would then buy the property back from my brother as both my parents head into retirement.  My brother believes, at that time, he and his wife will be in a better position to open their own vet practice and wants to use that rental property money for doing just that. 

Is your parent's home being exchanged under 1031 as well?  Because that part of the exchange may not qualify under 1031.  1031(a) says the property needs to be held for "held for productive use in a trade or business or for investment", and "investment" usually doesn't include a residence (unless you are super duper aggressive).  They can still "swap" properties, but the transaction may be taxable (although they may be able to exclude the gain under 121).  

As other posters have said, the related parties rules need to be adhered to.  Selling or exchanging (even in a 1031) either property within 2 years (even between the same parties) could result in the original exchange being taxable.  With taxes and penalties, that's not a good time.

Another thing to watch out for is that there's some guidance from the IRS that suggests that if fair market values of the exchanged properties are not equivalent, then your brother (assuming his property is worth less) may still have taxable gain.   IRS has opined that if one property is worth more than another, then the person receiving the property worth more is getting non like-kind property or some sort of other consideration. It's safest for the party(ies) claiming 1031 deferral to make sure that the property being exchanged has equivalent (or close to) fair market "arms-length" value.

If the dems take back congress in November, you could see rate hikes.  Gain deferral is nice if tax rates go down.  Not so much if they go up.  Tax rates for both ordinary and cap gains are good right now.  Might make sense to pay now rather than kick the bucket down the road.

The other part of this that adds hair to the deal is that the house is being leased back to your parents.  I don't think it is as concerning for the front end exchange, but it does add some uneasiness to the trade back (i.e., is a lease by your brother to your parents considered a trade or business/investment?). 

Also need to watch out for a deemed gift if your brother pays less than fair market value for the house. May or may not be a concern.

Why doesn't your brother identify property he can use for his vet business and buy that property (deferring gain under 1031) and short-term lease it until he moves forward?

 

 

[PilotsError 2345]

We are not a free people.

[Brew 3049]

If your parents and brother are fine with it, it is between them. Your parents have no risk in the situation as they can move again and your brother is the one deferring tax.

On the transaction, intent is just as important as timing. He has to intend to buy a new rental property to 1031 his gains and he has to intend to hold that property long term. He would likely lose those just for the record because your parents are picking out the home and they have agreed to buy it. However, short of them telling the IRS that it will be hard to prove. Once he gets past a year, he could sell the property to your parents and 1031 his proceeds into a new investment property. He will have a 2 year holding period on that property.