Rental Property Investor · Breckenridge, CO · Member since 2021 · 15 posts · 5 votes
Property A was owned by LLC A 50/50 me and another partner. After five years of LLC A owning Property A, I created LLC B with two extreme-minority partners (0.5% each, as a formality for lending purposes) and bought out Property A.
I used my $250k primary residence cap gains exclusion on this sale from LLC A to LLC B after having two tax years where Property A was not generating income (less than 14 rental days per year) and could be deemed a personal residence instead of investment property. Also didn't depreciate it as a business asset.
Sale price set a new cost basis for LLC B. Closing date of this sale from LLC A to LLC B was October 9, 2020.
Now Property A is going to likely be sold with closing in July or August, 2021...less than 12 months later. The gain is going to be extremely significant, likely a 50%+ increase from the 10/9/2020 closing.
It was not a flip and was not intended as such, it was used by LLC B as a long-term rental...but now taking advantage of market conditions, re-leveraging, etc.
QUESTION: is this a 1031 candidate, or am I running the risk of an audit at least, and possibly getting hit with massive cap-gains at worst? I'm hoping to 1031 into a larger MFH investment or self storage...but I've contemplated a good-looking OZ fund in Colorado as well. It sounds like the OZ option might be safe since there isn't a lot of "precedent" set yet, and it's relatively flexible in its interpretation of capital gains. But the 1031 option might be the way I'd rather go, I just don't want to find out I'm disqualified for it because of the under-365-day STCG issue...
I'm hoping to get someone who's been through something like this, either directly or as an advisor (accountant, attorney, QI, etc)
Nick,
Intent to hold for investment is the taxpayer's subjective intent. The IRS looks at objective facts and circumstances to determine if the taxpayer's intent was to hold property for investment. In Goolsby, the Tax Court held that the taxpayers did not prove their intent to hold property for investment at the time of the exchange. The taxpayers purchased the property, quickly moved into the property, and made minimal efforts to rent the property. In contrast, in Reesink the taxpayer made stringent attempts to rent the property, and only moved into it several months later when the real estate crash forced them to sell their primary residence.
You sold the property at FMV and then also rented. Now, you are taking advantage of appreciated market. You are not the only one who is doing this.
Lets see what @Dave Foster says, but I'm a little concerned...
How can you use the sec121 exclusion on a property in which Title was held by a multi-member LLC? sec121 exclusions are for persons, and you need to show that you were living there not just failing to rent it for a profit (or for that matter "put in service as a rental"). Anyway, the key is you need to have personally owned it which is a big reason why its not advisable to hold your primary residence in a LLC.
The length of time may raise a flag, but mainly you need to show justification that this is a rental property to be eligible, i.e. pass an audit (right? you can file anything, its just if somebody looks at your filing), for a 1031. It sounds a little tough since it hasn't been used as a rental much. Is it at least rented now? Are you selling it with a tenant? Was this just a 6month lease? Some of that I could accept, as a layman.
If you think your sec121 claim is clean and you have justification for the 1031, what does it hurt you to claim it? In the worse case, the IRS audits you and your 1031 is disallowed and you owe tax. While nobody wants to pay tax, weigh that against not selling...
Rental Property Investor · Breckenridge, CO · Member since 2021 · 15 posts · 5 votes
5y
@David M. I was mistaken slightly—Property A was titled to me and the other partner individually, and this was how I was able to claim my 121.
LLC B bought Property A with the intent to hold for at least a couple years, has been rented continuously under a 6mo lease (Nov 15 to May 31) and basically I'm just seeing the market opportunity.
I hope that makes sense...the 121 is solid, I just don’t know about the 1031 with a sub-12mo time frame...
As a layman, the 1031 sounds much more solid. You were leasing it.. the lease, albeit 6 months, was up, and so you took advantage of the market to sell and exchange for another rental. That seems reasonably justified to me... Remember, its not the timeframe, its the intent --- which is usually harder to prove in a short timeframe.
That sounds about right... If you do a "quick turn around" its subject to, or more likely, an audit. But, in my layman's mind, that doesn't mean it will be disallowed. You need to show sufficient justification --- not like dealing with an audit is any fun. Good luck.
I'm hoping to get someone who's been through something like this, either directly or as an advisor (accountant, attorney, QI, etc)
Nick,
Intent to hold for investment is the taxpayer's subjective intent. The IRS looks at objective facts and circumstances to determine if the taxpayer's intent was to hold property for investment. In Goolsby, the Tax Court held that the taxpayers did not prove their intent to hold property for investment at the time of the exchange. The taxpayers purchased the property, quickly moved into the property, and made minimal efforts to rent the property. In contrast, in Reesink the taxpayer made stringent attempts to rent the property, and only moved into it several months later when the real estate crash forced them to sell their primary residence.
You sold the property at FMV and then also rented. Now, you are taking advantage of appreciated market. You are not the only one who is doing this.
My only concern is that the property was held jointly with me and the other partner, I took the 121 exemption, and am now owning the property fully through LLC B and doing a 1031...within less than a year. I had full intent to keep it as a rental and can prove that, but I still am a little concerned about triggering an audit.
Do you think there could be a good argument to set a closing at 10/10/21? With this kind of market, it might not be an issue, especially with the timing of ski season. We could also rent it solid June-Sept and make a bunch of money on it.
Just don’t know what the risk level is with IRS red flags.
From what you posted, it appears it will get flagged being for less than 1yr1d. That's why my line of reasoning is can you survive the audit?
I don't know your market. Any way you go you will take on some risk. It sound like, however, it might be worth it to YOU to wait another 6mo so you can get across that 1yr1d. That will take care of the "automatic" red flag risk. You take the risk of your profits going up/down between the rent and whatever the market will bear when you sell.
Are you more concerned with being audited (mostly likely just on this transaction), in general? Or, passing/winning the audit?
Rental Property Investor · Breckenridge, CO · Member since 2021 · 15 posts · 5 votes
5y
I’m afraid of the unknown. Never been audited! I am not as concerned about this specific transaction as I am about what an audit entails and whether they then take the liberty to analyze my ten other partnership returns.
Do you guys think that going into an OZ fund would be less risk than a 1031? I’d been contemplating that option prior to any thought about the STCG/1031 challenge, and believe I have a good case to go in that direction.
Honestly I am straddling the line between diving in further with MFH and more active-value-add versus doing the safer and much lower return route of OZ in CO...
My only audits have been 'letter audits' --- where the IRS sends me a letter asking about a particular detail. For example, they said I owed them a boat load of money when in fact they didn't have a record of my estimated tax payments. Per their instructions, I faxed them my payment confirmation and in a month I received my refund. Another was about my passive activity losses. I actually made an error so with the help of the family accountant drafted a letter back explaining it and with a corrected return.
Again, just a layman here, but usually its just what I call a 'letter audit' --- they jsut send you a letter. To my understanding, its even rarer to have to actually meet with an auditor, much less have them decide to audit everything. This is why I'm not particularly concerned about your situation. Either you 'truthfully/faithfully' file your return with the 1031 and "nothing happens." Or, they do come back asking for justification on how its an investment property and in the worse case situation its disallowed and you have to pay a bunch of tax --- ie you don't go to jail. Just my layman's two cents here, remember...
Errors happen all the time. I have had it many times where the IRS send me an adjusted refund check and a letter with a quick summary. I then have to figure out what I did wrong on my return. yes, cue all the advice about paying for a professional to prepare my return so that I don't make mathematical errors or put something in the wrong field....
As for the OZ, I don't understand it as well. But, I thought the big issue is what happens when the provisions of the law expire in 2025'ish? The best case condition of the provision was that if you held the fund for 10 years, you would get a complete step up in basis. But, the only way to have solidly taken advantage of it was if you started the fund when the law was passed and sold just as it expired (assuming that there were no extensions provided). Otherwise, the OZ is just another investment in a distressed part of town. BEFORE you consider the OZ tax benefits, the deal has to work and the OZ benefits should be considered the "icing" on the cake. If the deal can't stand on its own, its not worth doing regardless if it qualifies for an OZ fund. I think the OZ funds are similar to the DST (Delaware Statutory Trusts) which are favored for their 1031 qualification and is basically a hands-off way to invest. But, there are no guarantees, if not less, with investing with a DST.
Oh, by the way, how would you figure the OZ is less risk than a 1031? Wouldn't you be getting your funds into the OZ via a 1031 anyway?
My only concern is that the property was held jointly with me and the other partner, I took the 121 exemption, and am now owning the property fully through LLC B and doing a 1031...within less than a year. I had full intent to keep it as a rental and can prove that, but I still am a little concerned about triggering an audit.
Do you think there could be a good argument to set a closing at 10/10/21? With this kind of market, it might not be an issue, especially with the timing of ski season. We could also rent it solid June-Sept and make a bunch of money on it.
Just don’t know what the risk level is with IRS red flags.
As you had mentioned earlier that your sec 121 is solid. So, I am not going to comment on that.
Although the duration is one of the areas that the IRS will look at, it is not the only determining factor. Just to give you an idea. IRS has safe harbor (safe harbor doesn't mean you have to meet this, but it gives audit protection) for 1031 exchanges for a second home to have 1031 respected. (Although your case is not the second home, I just wanted to give you an idea)
In Moore v. Commissioner,T.C. Memo. 2007-134 [TC Memo 2007-134], the taxpayers exchanged one lakeside vacation home for another. Neither home was ever rented. Both were used by the taxpayers only for personal purposes. The taxpayers claimed that the exchange of the homes was a like-kind exchange under § 1031 because the properties were expected to appreciate in value and thus were held for investment. The Tax Court held, however, that the properties were held for personal use and that the “mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence.”
However, Rev. Proc. 2008-16 provides a safe harbor for when a second home will qualify as held either for productive use in a trade or business or for investment purposes. Under Rev. Proc. 2008-16, the IRS will not challenge that a property qualifies for Section 1031 gain deferral if—
1. the relinquished property has been held for at least 24 months immediately preceding the exchange and in each of the two 12-month periods immediately preceding the exchange,
a. the taxpayer rents the residence to another person at fair market value for at least 14 days, and
b. the taxpayer does not use the property more than the greater of 14 days or 10% of the total number of days the property was used; and
2. the replacement property is held for at least 24 months immediately after the exchange and in each of the two 12-month periods immediately following the exchange,
a. the taxpayer rents the residence to another person at fair market value for at least 14 days, and
b. the taxpayer does not use the property more than the greater of 14 days or 10% of the total number of days the property was used.
Also, the property will simultaneously qualify for 1031 and 121 at the same time if the property was both primary residences and was an investment property. In your case, you have actually made a valid sale and converted it to the rental, so I would be confident on the 1031 exchange as you have rented the property and have intended to hold this property.
I would suggest not converting the replaced property into a primary residence right away. That might be a red flag.
Rental Property Investor · Breckenridge, CO · Member since 2021 · 15 posts · 5 votes
5y
@David M. thanks for the anecdotal experience, that’s good to hear from a more “DIY” perspective. I’ve always seen the risk in black and white, I.e. an audit = your life upside down for a year, no audit = all good. But I haven’t done any major transactions like this before that would ever raise a flag.
The DST sounds less interesting because it's such low ROI. I understand the reasons for it, but I think it's meant for a point much later when you want to fully remove yourself from day to day ops.
OZ is more complex in terms of the tax consequences, but I would correct you only on the fact that you didn’t need to join initially when legislation passed in order to make it happen. You just have less time before your initial cap gains are due, since all QOZ investments require a Dec 2026 deadline for payment of cap gains on what you put into the fund. Note: it does NOT involve a 1031 of any kind, and can be used as a backstop for a 1031 process in case it falls through.
@Ashish Acharya sage wisdom and experienced advice! I’d like to discuss a little more detail about this offline. Suffice to say, whatever replacement property I get, it won’t be used for 121 as it will almost certainly be MFH, storage, or OZ.
Speaking of 121, what if part of the house is rented, but it’s still one’s primary? Can you still get the 121 even if half the home is used as a lock-off rental?
@David M. thanks for the anecdotal experience, that’s good to hear from a more “DIY” perspective. I’ve always seen the risk in black and white, I.e. an audit = your life upside down for a year, no audit = all good. But I haven’t done any major transactions like this before that would ever raise a flag.
The DST sounds less interesting because it's such low ROI. I understand the reasons for it, but I think it's meant for a point much later when you want to fully remove yourself from day to day ops.
OZ is more complex in terms of the tax consequences, but I would correct you only on the fact that you didn’t need to join initially when legislation passed in order to make it happen. You just have less time before your initial cap gains are due, since all QOZ investments require a Dec 2026 deadline for payment of cap gains on what you put into the fund. Note: it does NOT involve a 1031 of any kind, and can be used as a backstop for a 1031 process in case it falls through.
@Ashish Acharya sage wisdom and experienced advice! I’d like to discuss a little more detail about this offline. Suffice to say, whatever replacement property I get, it won’t be used for 121 as it will almost certainly be MFH, storage, or OZ.
Speaking of 121, what if part of the house is rented, but it’s still one’s primary? Can you still get the 121 even if half the home is used as a lock-off rental?
Yes, even if the primary residence was house hacked, the section 121 still applies. (hopefully we are not taking about Duplexes)
The Unrecaptured 1250 depreciation doesn’t qualify for the exclusion.
Yes the DST is where you become a "silent partner."
When you rent out your primary residence, your taxes become "complicated." Basically, both aspects of having a residence and having a rental apply. So, you need to split your expenses into two buckets. One is you regular expenses. The other is for your rental. People try to say "75%" of the home is for rental, but long discussions thread have basically seem to come to the realization that while people file that way, it wrong. Only the percentage of sq ft that is dedicated to renting goes into that "rental bucket." This includes taxes, any utilities that can be actually attributed to renting, depreciation, etc.
Then when you go to sell, you have "all taxes" to consider, including the unrecaptured depreciation which Ashish reminds us the sec121 exclusion does not apply.
1031 Exchange Qualified Intermediary · Denver, CO · Member since 2017 · 174 posts · 96 votes
5y
I wanted to back up what @Ashish Acharya said for and concisely summarize for @Nick Frey and anyone dropping by this chain:
Yes, you can still do a 1031 exchange on a property held less than 12 months provided that you had/can show the proper intent. This happens all the time.
Property can qualify for Section 121 exemption and Section 1031 deferral simultaneously; the facts here matter a great deal and should be worked out carefully with an intermediary/CPA.
Unrecaptured depreciation cannot be exempted with Section 121 but can be deferred along with all other taxes in a 1031 exchange.
I do not believe that OZones can easily be used as a "break glass in case of emergency" when a 1031 fails. There is some debate here, but typically the gains from the sale of the investment asset must be reinvested into the OZone Fund within 180 calendar days, but you cannot get funds back from a failed 1031 exchange until day 181 after sale in many/most cases.
Rental Property Investor · Breckenridge, CO · Member since 2021 · 15 posts · 5 votes
5y
@Sean Ross thanks a ton. However I’m hearing conflicting info about (4) in your points. I’ve heard that OZ is a backstop from the OZ itself (not from some random source but an experienced equity partner describing around 20% of their commitments originating from this failed 1031) as well as in my own cursory research.
Real Estate Investor · Steamboat Springs, CO · Member since 2008 · 54 posts · 33 votes
5y
@Sean Ross I thought I’d weigh in on point 4) regarding OZs being a backstop for 1031. In my experience as a fund manager, it depends on the situation, the timing, and the investors access to cash. Until March 31st of this year an OZ fund was an easy backstop since the OZ investment 180 day investment window had been extended by the IRS through March 31, 2021 and the 1031 had not been extended. Now that the extension has expired it depends on the situation.
OZ funds and 1031 exchanges share a 180 day investment period after the date of sale. As you mentioned you often cannot get funds back from a failed 1031 exchange until day 181 after sale. For some people that will mean that they cannot make a timely investment into an OZ fund. However, unlike a 1031 which requires an intermediary and requires the specific cash from the sale to be invested into the exchanged property, the OZ regs do not require an intermediary and do not require that it is the same cash being invested. In the OZ world, you are required to invest within 180 days but money is fungible. If you still have your sales proceeds tied up with an intermediary, you can invest other cash into the OZ fund, and then simply have the intermediary return your funds to you from the failed exchange. It’s as if the 1031 never happened. Obviously this requires access to additional cash outside of the cash tied up with the intermediary, but it remains a possibility for use as a backstop. In practice, some intermediaries also return funds prior to the 181st day, whether they should or not.
Rental Property Investor · Breckenridge, CO · Member since 2021 · 15 posts · 5 votes
5y
@Chris Montgomery thanks for weighing in. Your 4P fund is the main one I’m considering in that space.
correct me if I’m wrong on this: property owned by a partnership (files 1065 and K-1s) sells asset closing July 2021. It would need to put money into OZ by mid-Sept 2022 based on required tax filing date (Mar 15, 2022) plus 180 days.
If that’s correct then I would get 1031 money back from QI at July 2021 plus 180 days (meaning mid-Jan 2022) and still have nine months cushion before OZ in mid-Sept.
On a related note, I’d love to hear your thoughts on MFH from a macro (national and political) perspective as it relates to net demand and supply. On the demand side, do you see inflation causing lower incomes to lift / debts to effectively have less negative value / credit ratings improve and therefore seeing people qualifying for first homes? Possibly a loose lending environment due to liberal politics making huge concessions for first time homebuyers, more down payment support, etc?
On the supply side do you see massive wealth dumping into funds like yours over supplying the MFH market over the next few years? I see 1031 and OZ activity spilling so hard into new projects I can’t help but feel it’s more money chasing fewer opportunities and possibly creating a supply bubble over a mid-term time scale of 3-5yrs.
I've ridden the "equity wave" with SFR and see at least a mid-term top this year...or at least I'm not a buyer in this climate and partially a seller. But I'm wary of being a buyer into a market going in reverse due to macro issues...and no matter how strong the local environment looks, it's unpleasant to see that thesis overwhelmed by large-scale movements.
Thanks in advance (from a guy who’s very interested in investing in specifically what you do)!
Real Estate Investor · Steamboat Springs, CO · Member since 2008 · 54 posts · 33 votes
5y
@Nick Frey Thanks for the vote of confidence in what we’re doing in opportunity zones at Four Points.
You are correct. The situation you outlined above is one of the other scenarios where an OZ fund can be a good backup or alternative to a 1031. If your capital gain is coming to you through a partnership, your 180 investment clock does not begin until the (unextended) due date of the partnership tax return. For a calendar year partnership that day is March 15, so you have 180 days from the March 15 to invest in a partnership. In your example of selling a property in July 2021, your partnership return is due March 15 2022 and you could have until mid September 2022 to invest into an OZ fund. Plenty of time to receive your funds back from an intermediary if you decide to initially pursue a 1031 which does not move forward. One note: if the partnership sells the property in July ’21, and the partnership will not be investing into an OZ fund as a partnership, the partners individually have the option to invest immediately after the sale of the property OR they have the option to wait and start the 180 day clock on March 15. If you’ve already decided to not pursue the 1031 you don’t have to wait to invest in the OZ fund.
As for your second question about multi-family supply and demand, that a bigger, complex question. We should discuss over a beer sometime. Personally I think it’s a complex and nuanced answer that depends on macro, local and political issues. As you know, we’re focused exclusively on Colorado and to an extent Utah. There is an extreme housing shortage in the middle income area with all trends pointing to an increase of people moving into our area. Even then, we don’t look at the Colorado market as one market but look at each sub-market individually and right size each of our investments to the local market with every investment decision based on our expectations regarding demand, potential for absorption and strong visibility into the supply entering the local market.
Your point is a good one, and I tend to agree that more and more money will be entering the market in Multi Family Housing whether through OZ funds, 1031 or traditional investment. When money chases an opportunity at scale there is always the risk of a market being flooded and our local focus is not immune from national trends. The counter balance to that concern is that construction costs are high and every deal needs to make sense as you balance cost, risk, and potential income. Candidly, it can be hard to make deals work. To a degree that development challenge puts the brakes on money flowing into certain areas too quickly. We are also in a low interest rate world and if/when those rates increase it will also tend to have a slowing effect on new development.
I think I just typed a lot of words to say ‘It depends’. Let’s grab that beer sometime and discuss. The opportunity zone incentive is a massive tax incentive that requires a 10 year hold period. To maximize the value of the incentive the OZ fund ultimately needs to be investing in projects that make financial sense. The 10 year hold is both a challenge and an opportunity. Knowing up front that we are going in with patient capital we can focus on building a high quality product in an area that shows increasing demand. Will our forecast be perfect over 10 years? No. But if we do our job right, we’ll have a quality cash flowing project, have a tax free exit after 10 years that avoids depreciation recapture, have control over our exit timing, and make a positive impact in our communities.
Rental Property Investor · Breckenridge, CO · Member since 2021 · 15 posts · 5 votes
5y
@Chris Montgomery thank you very much for that thoughtful answer. I would definitely like to have a beer and discuss...I highly value the structural barriers to entry in the small and desirable areas of CO, this has been my entire thesis since 2012. I don't see those opportunities in SFH anymore, and I've always been curious about using MFH to address their independent (yet similar) housing crises. It's just almost impossible to bring units online! Which is why 4P has really been of interest.
I'm hoping to get someone who's been through something like this, either directly or as an advisor (accountant, attorney, QI, etc)
Nick,
Intent to hold for investment is the taxpayer's subjective intent. The IRS looks at objective facts and circumstances to determine if the taxpayer's intent was to hold property for investment. In Goolsby, the Tax Court held that the taxpayers did not prove their intent to hold property for investment at the time of the exchange. The taxpayers purchased the property, quickly moved into the property, and made minimal efforts to rent the property. In contrast, in Reesink the taxpayer made stringent attempts to rent the property, and only moved into it several months later when the real estate crash forced them to sell their primary residence.
You sold the property at FMV and then also rented. Now, you are taking advantage of appreciated market. You are not the only one who is doing this.
