Tax help: Selling house with handshake equity agreement

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Tax help: Selling house with handshake equity agreement

Palmer Thomas
Member since 2015 · 53 posts · 88 votes

I have a rental house I'm in the process of selling.  When I first purchased the house, it needed a lot of work.  I have a friend who is good at doing just that so I agreed that I would give him an equity stake in the house to match the percentage of the value of work he did.  After rehab, he now owns 30% of the property.

Since this was a house I purchased in the beginning of my real estate adventures, I had no idea about long term tax implications. I didn't put him on either the title or put him as a member of the LLC under which the property is owned. There is no paperwork at all drawing up the agreement. It was just a friend to friend handshake deal. From a combination of the rehab and appreciation the house value has gone from roughly $50k to $200k.

How can I get my friend his share of the profit without being double taxed (I pay taxes on sale then he pays taxes when I give him his share) all while trying to do a 1031 exchange with my portion of the sale?

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  • Andrew FreedBusiness Member
    Investor · Worcester, MA · Member since 2020 · 1k+ posts · 1k+ votes
    3y

    @Palmer Thomas - When you sell it, can't you just add a fee on the HUD statement for his work? As a result, your take home funds will be the profits minus the 30% equity. That sounds like the cleanest solution, he will then pay taxes on the rehab fee he gained from the transaction. Definitely talk with an attorney and CPA before moving forward with this though.

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  • Brandon BruckmanPro Member
    Financial Advisor · Milwaukee, WI · Member since 2018 · 110 posts · 96 votes
    3y

    Its CPA time!  

    Would you consider adding your friend to the LLC? Would he like to be involved in your next investment?

    Or you might be able to restructure ownership as tenant in common.  Then both could 1031 exchange and go your separate ways.  

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    3y

    @Palmer Thomas, What your friend has is an unrecorded interest in that property.  I'm sure you have ample documentation outlining the deal.  But for you to do an effective 1031 exchange that doesn't double dip you, you'll need to record their interest.  The title company closing the sale can do that right before the sale happens.  Each accountant will report the sale of your individual interests.  And you go forward with a 1031 exchange on the sale of your 70%.

    Just make sure to alert the accountants ahead of time so they understand it will not be a deemed sale but rather a recognition of substance over form in regards to the unrecorded interest.

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  • Eric Williams
    Accountant · Houston, TX · Member since 2023 · 147 posts · 41 votes
    2y
    Quote from @Palmer Thomas:

    I have a rental house I'm in the process of selling.  When I first purchased the house, it needed a lot of work.  I have a friend who is good at doing just that so I agreed that I would give him an equity stake in the house to match the percentage of the value of work he did.  After rehab, he now owns 30% of the property.

    Since this was a house I purchased in the beginning of my real estate adventures, I had no idea about long term tax implications. I didn't put him on either the title or put him as a member of the LLC under which the property is owned. There is no paperwork at all drawing up the agreement. It was just a friend to friend handshake deal. From a combination of the rehab and appreciation the house value has gone from roughly $50k to $200k.

    How can I get my friend his share of the profit without being double taxed (I pay taxes on sale then he pays taxes when I give him his share) all while trying to do a 1031 exchange with my portion of the sale?

    He should have been taxed in the year the services were provided equal to the fair market value of the property received. 

    You would have a deduction for that same value.

    Instead you created a partnership with its own filing requirements, and potential liabilities. If he did have an equity interest he would have been receiving a distributive share equal to that interest every year. If he didn't, you got taxed on income that should have gone to him. 

    I mean at this point it might be easier to just give him his share of the RECOGNIZED GAIN (those words are critical).

    Yeah honestly you don't need paperwork to create a partnership at any level, for better or worse - substance over form.

    On top of that you violated 721 and made it a taxable transfer.

    1.61-2

    (d) Compensation paid other than in cash—(1) In general. Except as otherwise provided in paragraph (d)(6)(i) of this section (relating to certain property transferred after June 30, 1969), if services are paid for in property, the fair market value of the property taken in payment must be included in income as compensation.

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