LLCs and 1031

6 Replies

Ok so here is my question...I'm just getting started out in the idea of real estate investment and whatnot. I am only 27, a lawyer and I work a 9-5 that I like. My mother is closer to retirement age and has wanted to design and flip houses her whole life. So we started a little LLC with just the two of us. We want to flip houses, and maybe down the line get into having a few rental properties. Now don't let the fact that I have a legal background deceive anyone...Basic Income Tax was NOT my strong suit and I barely passed the class in law school! So while ultimately we will have the help of a CPA when we file taxes (haven't even purchased our first property yet), I am still trying to get a grasp of capital gains taxes on investment properties, when you can use 1031 form, etc.

Any information pertaining to those issues with regards to an LLC would be so helpful and appreciated!!

Thanks so much! 

Hi MacKenzie,

Congratulations on joining Bigger Pockets and welcome! 

I will jump in here on the topic of 1031 Exchanges. 

The first requirement in order to qualify for 1031 Exchange treatment is that the properties involved must be held for rental, investment or business use.  Properties that are acquired and held for sale such as rehabs, flips, development, etc., are actually treated as inventory in your real estate business and therefore held for sale (as opposed to investment) and do not qualify for 1031 Exchange treatment.  So, any properties that you and your mother buy to rehab will likely not qualify, but those that you buy, rehab and then actually do hold for rental/investment purposes would qualify. 

The key issue is your intent to hold for rental or investment purposes.  If you do a lot of rehab/flip, you will have to go overboard on those that you hold in order to demonstrate that those specific properties were intended as rental/investment properties.

Finally, the issue of the LLC. Your LLC is a two person LLC and unless you elect otherwise will be treated as a partnership for income tax purposes, so any 1031 Exchange transactions would be structured under the LLC's name as a partnership. If you and your mother ever decided to wind up the LLC and go separate ways, you would need to make some proactive changes to property held for rental/investment purposes in order to qualify for 1031 Exchange treatment.

Medium exeter 1031 clr cntr bBill Exeter, Exeter 1031 Exchange Services, LLC | [email protected] | (619) 239‑3091 | http://www.Exeter1031.com

Dont worry about 1031. Figure out what you want to do with real estate first. You can figure out the 1031 later when you actually decide to sell. If you are buy and hold investor this may be 50-60 years in the future (you are young) and by that time there may not be 1031 exchange or there may be something better.

I'm not a lawyer. I'm not an accountant and I cannot give you an advice but from what i've heard 1031 is a way to defer your tax bases until a later period. there are a lot of limitations though. The property you are buying has to be of the same type. the new property has to be more expensive than the old one (If it is not you may have to pay taxes on the difference). the owners of the old and the new property should be the same (i.e you cannot add or remove owners - it can cause taxable event). you also have a very limited time to identify and buy your second property. this is why 1031 guys specify this on their MLS. because they would like to delay closing until they lock their next property.

@Mackenzie Wallace  That's somewhat of a loaded question only because there are so many tax implications that can be addressed. 

As far as capital gains tax goes, you are only taxed on your profits once the property has been sold. If you held the property for less than a year, you will be subject to short-term capital gains tax which can be steep (up to 35%). If you hold the property longer than a year, you will be subject to long-term capital gains tax (15-20%). 

Also, the general consensus is to never flip properties in a LLC unless it is taxed as an S-Corp. Your earnings in the LLC will be subject to Self Employment taxes but in the S-Corp, you will have some control over the amount of SE tax you pay. A more cost effective method is to simply purchase an umbrella insurance policy.

There are plenty of tax strategies you can utilize to reduce your tax liability. If you have more specific questions, feel free to PM me.

Medium logo blackBrandon Hall CPA, The Real Estate CPA | http://www.therealestatecpa.com | Podcast Guest on Show #196

Originally posted by @Bobby Narinov :

I'm not a lawyer. I'm not an accountant and I cannot give you an advice but from what i've heard 1031 is a way to defer your tax bases until a later period. there are a lot of limitations though. The property you are buying has to be of the same type. the new property has to be more expensive than the old one (If it is not you may have to pay taxes on the difference). the owners of the old and the new property should be the same (i.e you cannot add or remove owners - it can cause taxable event). you also have a very limited time to identify and buy your second property. this is why 1031 guys specify this on their MLS. because they would like to delay closing until they lock their next property.

Hi Bobby,

I wanted to clarify a few items here. 

I think you are combining two requirements here for a successful 1031 Exchange transaction.  The first is that the properties must satisfy the Qualified Use requirement, which I discussed in my post above.  The second is the "like-kind" requirement.  In the real estate context, like-kind simply means any kind of real estate can be exchanged for any other kind of real estate as long as it meets the Qualified Use test. 

There is a way to add owners as long as they are considered to be investing on a individual basis for tax purposes.  Generally, this is accomplished by each investor taking title as a tenant-in-common.  The portion/fractional percentage of the property that is acquired by the party completing a 1031 Exchange must have a value equal to or greater than his/her sale property.

Medium exeter 1031 clr cntr bBill Exeter, Exeter 1031 Exchange Services, LLC | [email protected] | (619) 239‑3091 | http://www.Exeter1031.com

Originally posted by @Bill Exeter : The second is the "like-kind" requirement.  In the real estate context, like-kind simply means any kind of real estate can be exchanged for any other kind of real estate as long as it meets the Qualified Use test.

Are you sure about that? I though you cannot exchange a rental for a hotel. I also don't think a second home, vacation home, etc. can be exchanged for a rental home.

Originally posted by @Bobby Narinov :
Originally posted by @Bill Exeter: The second is the "like-kind" requirement.  In the real estate context, like-kind simply means any kind of real estate can be exchanged for any other kind of real estate as long as it meets the Qualified Use test.

Are you sure about that? I though you cannot exchange a rental for a hotel. I also don't think a second home, vacation home, etc. can be exchanged for a rental home.

Yes, I'm positive.  The like-kind requirement means real estate for real estate.  It has nothing to do with the actual asset class.  Second homes, vacation homes, etc., may qualify depending on whether they are rented out, held for investment or personal use is involved, etc.  It is a case by case basis.  Again, the important point is the Qualified Use test, which is the properties must be held for rental, investment or business use.  The like-kind requirement is easy, the properties must all be real estate. 

Medium exeter 1031 clr cntr bBill Exeter, Exeter 1031 Exchange Services, LLC | [email protected] | (619) 239‑3091 | http://www.Exeter1031.com