I'm looking for some advice on how to best defer capital gains taxes on my next fix and flip project. I'm partnering up with my brother in law to flip a house that he owns but has been renting for just under 2 years. He purchased the home in 2010 and lived in the residence for 3 years prior to moving and renting it out, he is currently renting the home he lives in now and owns no other property. We have started the process of forming an LLC and I am currently working with a friend who is also a RE attorney to help guide me on the proper formation of the business. Here's what I would like to know:
Option 1 would be to transfer title of the home into the LLC's name, fix and flip the porperty, and do a 1031 exchange to defer capital gains? I have spent some time on this forum and also online researching the ins and outs of how a 1031 exchange works so I am somewhat familiar with the process.
Option 2 would be to keep title in my brother in laws name and since this was his primary residence for 3/5 years have him sell the home without having to pay capital gains (at least this is my understanding of how the law works). I would work with my attorney to make sure that all the legal paperwork is in place to prevent this deal from getting sideways on me.
I do understand that that there is more risk with option 2 since I would not actually be on the titile of the property but I do like the idea of having access to our profits right away without being forced to adhere to some of the guidlelines within a 1031 exchange. I am open to any thoughts or opinions that you may have, thanks in advance for the help!
Your options are surprisingly limited on this first transaction. First thing you need to do though is eliminate the words fix n flip from your vocabulary. When you fix n flip your intent from the day you take title to the property is to sell that property. That is precisely the behavior prohibited if you want to do a 1031. In order to be eligible to do a 1031 your intent must have been to hold the property for productive use in business trade or for investment. By renting that property for 2 years your brother has demonstrated that intent so he could do a 1031. But if you put yourself on title you would be seen as doing so in order to flip the property so no go on the exchange.
In my opinion the biggest advantage would come from your brother selling the property and taking the sec 121 primary residence exclusion. He actually only has to have lived in it for 2 out of the previous 5 year period and the gain up to $250K if he's single or $500K if married would be tax free. Because he has operated it as a rental he would have to recapture the depreciation taken during the time as a rental.
By doing this you avoid the potential entanglement of demonstrating intent on a 1031 and you avoid the cost of a 1031 all together. Your brother can just as easily contribute cash into the LLC you form and then you can be off the the races - just not fix n flipping if you want to do 1031s.
Dave is exactly right, additionally you want to consider what your goals are. If you just want cash, then option number 2 is your best bet as you can take out the cash from the property sans capital gains. If your priority is to buy another property or leverage up, then option number 1 seems like the better alternative. Keep in mind if you choose option number 1 you have a very strict time frame to adhere to once you sell your property.
Another option to look into would be a reverse 1031 exchange, but I would suggest you consult an attorney and/or your accountant before making any major decisions.
I would lean toward the 121 Exclusion (Section 121 of the Internal Revenue Code) because it would lock the gains in tax-free (vs. tax-deferred through a 1031 Exchange). You can decide how to redeploy the cash after the tax-free sale transaction has closed and you will have much more flexibility at that time. Your brother has a three year window from the date that he moved out of the property to close on a sale in order to qualify for the 121 Exclusion, and locking in tax-free gain today since you qualify and then reinvesting makes a lot more sense than just deferring it.
Taxpayers can take advantage of the 121 Exclusion once every two (2) years, so your brother would not be losing anything in the future.
@Zachary Harrell I was slightly confused by your post, can you clarify something for me. My intent is to free up as much capital as possible to purchase another property. Based off of the advice from @Dave Foster and @Bill Exeter the 121 exclusion sounds like our best bet but if I misunderstood something let me know.
I only have experience in 1031 exchanges so that may explain my preference, but I am not advocating either one. Dave and Bill both brought up very good points, but I would suggest you consult an attorney or your accountant before making any decisions as they will be able to advise you as to the best option for your current situation.
With the sec 121 exclusion you either qualify or you don't. If you meet the criteria (live in it for 2 out of previous 5 and haven't already done this within the last two years) then you can simply sell and take the proceeds tax free up to the limits. No capital gain, no need to reinvest nada. It's as easy as it gets. Your cpa can tell you if you qualify very easily.
the 1031 exchange requires advance planning so it is in place at the closing of the sale. It has specific requirements regarding process that must be met. You have to use the services of a qualified intermediary and there is a cost involved.
Both processes will save tax dollars. the Primary residence exclusion is tax free. The sec 1031 exchange of investment real estate is tax deferred. That's why both QIs on this forum recommend that you see if you qualify for the primary residence exclusion - it's tax free, it's easier, and it doesn't cost money.
I understand, that's my plan and was just trying to get clarification on @Zachary H. 's post. We're moving forward with the section 121 exclusion as my partner will qualify for that. Thanks again for the help.
Ditto with the above mention of the 121 exclusion. That's the route I would go. Not sure how close and trusting you are with your brother-in-law thus, you can always secure an option on the property for lump sum or percentage of the sale if your tie the property up and conduct a dry escrow/simultaneous close. Or you can secure a simple assignment to you when the house sells. In others words do the numbers, figure what you want out of it and write an assignment. The title company will issue a check to your name.
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