1031 to a Spec Home from our company

St. George, Utah
1031 Exchanges
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1031 to a Spec Home from our company

Amelia Gull
Member since 2024 · 3 posts · 1 vote

Hello,

I'm new to this community, and value the knowledge base here! My husband and I own 2 rental properties (1 has been rented for 10+ years, and the other for 1+ year). The newer property just isn't cash-flowing the way we'd like it to be, so I'm looking into the viability of a 1031. The properties are owned under our personal names. 

My husband is also a builder, and he is building a series of spec homes that have more bedrooms and would rent for more (fixing the cash-flow problem). If we built one of these spec homes (owned as our company), and then did a 1031 exchange under our personal names, is that viable because the parties are two separate tax entities? We are an LLC, taxed as S-corp, with K-1s. We asked our current CPA, and he's not completely sure since it's a pass-through tax situation. Tried calling the local CPA's that are "experts" at 1031s, but they aren't responding because it's busy tax season...I'll dig in deeper with tax people if it's a possibility, but wanted to throw it out there to this community first.

Any insights are much appreciated!

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Wayne Brooks
Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
2y

@Amelia Gull @Dave Foster can answer about any non arms length issues…he’s our expert.

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    2y

    @Amelia Gull @Dave Foster can answer about any non arms length issues…he’s our expert.

    1Reply
  • Sean RossPro Member
    1031 Exchange Qualified Intermediary · Denver, CO · Member since 2017 · 174 posts · 97 votes
    2y

    @Amelia Gull, you're situation intersects with a couple different 1031 rules.  

    (1) It sounds like your LLC is a separate tax filer, but the issue you may run into is that the IRS makes it tricky to buy from "related persons" under IRC 267(b) (a category that includes business entities) in a 1031 exchange. Are there any other members in the LLC besides you and your husband?

    (2) While it's usually recommended to own a property and treat it as an investment for at least 24 months before doing a 1031 exchange, this isn't a hard and fast rule.  Most accountants will be comfortable with an exchange on a property that you've owned 1 year and change.  We see exchanges that look like this frequently. 

    My guess from reading the information you've given is that your LLC is going to be considered a related party in a 1031.  

    [email protected]888-899-1031
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  • Amelia Gull
    OP
    Member since 2024 · 3 posts · 1 vote
    2y
    Quote from @Sean Ross:

    @Amelia Gull, you're situation intersects with a couple different 1031 rules.  

    (1) It sounds like your LLC is a separate tax filer, but the issue you may run into is that the IRS makes it tricky to buy from "related persons" under IRC 267(b) (a category that includes business entities) in a 1031 exchange. Are there any other members in the LLC besides you and your husband?

    (2) While it's usually recommended to own a property and treat it as an investment for at least 24 months before doing a 1031 exchange, this isn't a hard and fast rule.  Most accountants will be comfortable with an exchange on a property that you've owned 1 year and change.  We see exchanges that look like this frequently. 

    My guess from reading the information you've given is that your LLC is going to be considered a related party in a 1031.  

    Thank you for these responses!

    Yes - my husband and I are the only members of the LLC, so it’s likely we will be considered “related persons”.

    As a side note, by the time we intend to list the home, it will have been rented for 24+ months. 

    So it sounds like I likely have 2 options:
    1) just sell the property and eat the Cap Gains tax and move on, or
    2) do the entire exchange under our personal names and do a “improvement exchange” and book it through the home build. (We have been completing these specs in less than 5 months, so it could be possible, but stressful!)
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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    2y

    @Amelia Gull, I don't see an issue with the length of hold.  There is no statutory holding period.  The mantra in our industry actually used to be 1 year and a day because that would create two separate year tax returns reporting the property.  No magic to that however.  the standard is your intent to hold for productive use.  And your history certainly bears that out.

    Where the issue is going to be is with the related party you are wanting to purchase from.  Again, there's no statutory prohibition.  But the IRS does have an issue with buying from a related party to complete a 1031 exchange when there is an attempt to avoid tax.  Your personal tax return shows both your rental's activity and the activity of the S corp entity although on different schedules.   If the two of you were simply individuals owning the property as tenants in common and neither of you owned more than 50% of the entity then you could make the case that it was not a related party transaction.

    My fear is that if audited the exchange would fail due to the closeness of the related transaction.  You'd have an argument.  But the argument would he stronger if there were a 3rd member of that s-corp. .

    The 1031 Investor5137 Reviews
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  • Amelia Gull
    OP
    Member since 2024 · 3 posts · 1 vote
    2y

    Thanks for these details! It was just the clarification that I was looking for.

    Any tips, thoughts, or things to be careful with on doing a quick build via an “Improvement Exchange”? I want to take a look at that option again, although it seems complex. I would likely be able to close on construction financing immediately upon the first home close, and likely have permits ready to go as well. 

    1Reply
  • Sean RossPro Member
    1031 Exchange Qualified Intermediary · Denver, CO · Member since 2017 · 174 posts · 97 votes
    2y

    @Amelia Gull, improvement exchanges aren't the deepest end of the 1031 pool, but they are pretty close.  Here are a couple of factors to consider (and facts to know):

    - The financing portion can be very tricky if your lender is not familiar with the improvement exchange structure. Remember, your QI has to create a new titleholding entity to take title to the land while your spec house is built. The lender might balk at the thought of a brand new LLC (with no assets or income) suddenly becoming its borrower. Your QI should be adept at assuaging the lender's concerns.

    - Expect to spend more in fees.  A standard 1031 usually costs around $800 - $1,200, but you're likely to see improvement 1031 fees in the $5,000 - $10,000 range. 

     - When you are identifying replacement properties in an improvement 1031 exchange, you want to formally identify not only the address of what you want to buy but also a description of what you want to build/improve.  This is a mixture of both art and science. You should work closely with your QI on this. 

    - For purposes of trading equal or up in value (which is necessary in a 1031 to defer all taxes), the value of the property you build is purchase price at time of acquisition + cost of improvements completed before the exchange completes.  Some people get tripped up thinking "I bought all this raw material and left it on site, and that should count toward my value".  It doesn't, sadly, unless those materials are permanently affixed to the real estate. 

    -     You mentioned that you've been completing the spec homes in less than five months, which works nicely within an exchange timeline (180 days). It should also help you get around the issue I just mentioned above.

    - Permits must be ready to go right away, as you mentioned. 

    - When you pick a QI, ask them if they plan to wrap up the improvement exchange by either (1) an assignment of interest in the titleholding company or (2) a deed transfer from the titleholding company to yourself.

    [email protected]888-899-1031
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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    2y

    @Amelia Gull, if your husband is the builder then there is probably no reason to go through the mess of a reverse construction exchange.  The builder will simply let you know when the house is close to completion so you can then sell your old property and buy the new one using a regular 1031.

    With an improvement exchange, you've already sold your old property generally.  And the proceeds from the sale (plus the balance from anywhere else) are used for us, as the QI, to purchase the property.  While we are in title you are in control and funds from the exchange account (or anywhere else) can be used to improve the property.  Once the property cost plus the improvements is equal to the net sale of your old property we then close out the exchange and you own the new property.

    Actually not all that difficult to do.  Financing, and cost of the improvement exchange are the main reasons people decide not to do them.  But in the right situation they can be very powerful.

    The 1031 Investor5137 Reviews
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