Converting private residence to rental and using 1031 exchange

4 Replies

I'm new to Bigger Pockets and have a question I haven't seen addressed. I am a 15% owner of an LLC that is selling a manufactured home park. Can I do a 1031 exchange for my own private residence that I am converting to a rental? So I would purchase and move in to a new home and begin renting our current. Then the LLC (via a "swap and drop", structured so just I am responsible) would purchase/exchange (at FMV) our current home as a rental/investment property. The benefit for me is that I could retain the property with no current tax cost because the gain on the sale/exchange (up to $500,000, which is about what we have on ours) is excluded under Sec. 121. Then I would just continue to rent the house at the stepped up basis. Here are the only articles I found that seem to indicate I can:

https://www.thetaxadviser.com/issues/2008/jul/convertingaresidencetorentalproperty.html

- Under second section called “Sale to Controlled Entity in Lieu of Conversion”.

https://www.realized1031.com/blog/you-can-do-a-1031-exchange-on-a-primary-residence-heres-how

- Whole article.

Any insights would be appreciated.

@Gregg Tucker , I think what you're saying is that you would sell your current primary residence to the LLC and take advantage of the primary residence exclusion. That works fine.

The LLC is going to sell the MHP and do a 1031 exchange. One of their replacement properties would be your former primary residence. Again that's fine. At 15% ownership you are not a related party.

Once the LLC has completed it's 1031 exchange it will dissolve and distribute the assets of the LLC to the former members - again fine. Will that house equal your 15% membership interest?

It feels kind of "step - ish" as a transaction.  So you'll want to verify with your cpa.  But I think your minority membership will allow it.

The keys of course are that the LLC will have to do the exchange. And the LLC will have to dissolve in order to complete the Swap and Drop. And the house will have to approximately equal your 15% share. And all LLC members are on board with this strategy.

I'm thinking it must be a heckuva rental to be worth all those extra steps rather than just selling and taking the cash tax free.  Even the article you reference says that this is done for "non-economic" reasons.  A higher priced property isn't going to usually be a great rental.  A former primary residence rarely makes for the best rental.  

Do a comparative analysis on just selling and taking the cash and keeping your interest in the LLC or have the LLC buy different cash flow properties for you.

@Dave Foster , thanks for your input. Good stuff! Your summary is accurate.

Regarding your question about the value of the house, it is NOT equal to my 15% membership interest. It is only about 1/8th of my interest. You said, “The house will have to approximately equal your 15% share.” Is there a reason it could not just be a fraction of my interest?

Also when you say, “It feels kind of ‘step-ish’ as a transaction?”, do you mean there are a lot of steps or that it is a way to get a stepped-up basis? I was a little confused.

My plan is to take my proceeds from the sale of the MHP and exchange into a few different "properties" in order to diversify my investment portfolio. Part will actually "exchange" into Premium Shares of the publicly traded company that is purchasing our MHP (kind of like an upREIT, so it's tax-deferred). Part will likely exchange into a few DST's (possibly with other members of the LLC). And I was hoping to exchange part into a local multi-family investment property. As I looked around, I realized we are living in a pretty ideal investment property. The upper two floors is ~2,400 sqft, 5BR/3BA (with kitchen). The basement is ~1,200 sqft, 3BR/1BA (with kitchen). And we have just begun plans for a 650 sqft, 2BR/2BA (with 1-car garage) Accessory Dwelling Unit (ADU) in place of our garage.

My thought was by exchanging into my Primary Residence (converted to a Rental), I am essentially getting the appreciation I have realized (~$500,000) tax-free in the equity of the home after the stepped-up basis. If I just converted it to a rental without 1031 exchange/purchase, I would lose the Section 121 exclusion after 3 years. It seems like this gives me the best of both worlds. But I may be missing something in my thought process. Curious your thoughts. 

@Gregg Tucker , "step-ish" as in Step Transaction, an IRS term for a series of transactions whose sole purpose is to avoid a taxable event.  They like to keep a very fine line between following the letter of the law and creating an artificial situation just to avoid taxes.  I don't think this would be a step transaction but I'd vet it further up the chain because it's got the "feel".  

The house could be a fraction of your membership interest and the other properties you mention could equal the balance.  Sorry for the confusion on that.

Before I went to these lengths I'd take an isolated look at your house.  If it was on the market tomorrow for the same price/terms/rental prospect would you buy it?  If so then these steps are worth looking at doing.  I just see so often that primary residences don't make the best rentals.  

And although you'll get the $500K exemption I don't think you'll be getting the step up in basis. You'll be getting the basis that the LLC has in it when you accept it in the dissolution of the LLC. And that basis is the basis for the LLC after the exchange.

@Dave Foster , thanks again for the input. I will definitely consult with our CPA on this, especially the Step Transaction aspect.

I like how you put it when you simply ask, “If it was on the market tomorrow for the same price/terms/rental prospect would you buy it?” That is mainly what it comes down to. I assume there are some advantages to renting out a property I am really familiar with and it is nice to have a portion of my exchange that would be pretty much a guaranteed close, but the bottom line is whether the return on what I have invested in it is worth it. I’m pretty sure it is, but I need to do some more due diligence on that. 

The part I had the least clarity on was whether I could make the transaction even though the house is currently my primary residence but would be converted to a rental after. I didn’t know if it had to be a rental property for a certain amount of time before the transaction. It sounds like I’d be okay as long as it served as a rental for 12-24 months after the transaction. Anything less would raise some red flags. Does that sound accurate?

Regarding the “stepped-up basis”, you are correct. My/our basis remains the same when we exchange it in, which is quite low and why I hope to 1031 exchange most of the proceeds. I think I was trying to refer to the $500,000 exemption which essentially increases the basis on that money when we purchase a new private residence with it. That is, the $500,000 gain is tax-exempt. 

Thanks again. 

-Gregg

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