Calling all 1031 Exchange experts - Off standard question

13 Replies

As part of my partner and I's year two growth strategy, we will each be purchasing a duplex with an FHA loan that we plan to separately house hack for two years (me with my girlfriend, he with his current roommate). After occupying them for 2+ years we will then be looking to 1031 exchange them both to size up under our LLC. While living in them we will be pooling capital together, equal contribution, to perform a live-in rehab to both properties to force appreciation over the two years we occupy the properties.

Disclaimer:  I have a very beginners level understanding of all of the principles being discussed and will be covering all of this this with my CPA and attorney in the future, but I first wanted to educate myself with the help of the experts of BP in advance.

My question is, what is the best path to get these properties from our individual names and into the LLC when we 1031 the two properties to size up into the new property/properties? Could we each get an FHA loan under our LLC/Partnership and sign as a personal guarantor; he as a personal guarantor on his duplex and me on mine, so that for tax purposes when we go to exchange we aren't transferring the taxable owner and nullifying the opportunity to 1031 exchange it? Is that even possible/qualifying? If yes, I guess my next question would be will we be able to obtain a FHA loan under the LLC by signing as a single personal guarantor on the loan?

Thanks in advance for any and all help, and please let me know if I was unclear in any way (I know this is a bit of an oddball question).

I will try and ping an expert for you.  See if he has time to help.  @Bill Exeter ?  

It's simpler than you think. First, as you probably know, FHA loans are for owner occupants only, so LLC's aren't allowed. Primary residences do not qualify for a 1031. when you sell your primary residence, after at least two years, the gain is tax free. Now, you'll have half primary residence and half rental property, so maybe Bill can address the tax implications of the "rental half". Not sure how that is handled, if it's still considered your primary for the 121 primary exclusion, but I don't think so.

@Brandon Hartman

@Wayne Brooks is right.  Once you cut through the particulars your situation can actually be simpler and more advantageous than you are perceiving now.

When each of you buy your duplexes you will be using them for two purposes - primary residence and investment purposes.  For simplicity let's assume that all 4 units are of equal size so that each of you are living in 50% and renting 50% of each.

When you sell you will want to use two opportunities available to you.   First you will each use the sec 121 primary residence exclusion to exempt 50% of the gain tax free up to $250,000.  You can do this because you have lived in 50% of the property foe 2 of the previous 5 year period.  This money is yours to use however you want.

Secondly you will each want to do a 1031 exchange on the other 50% of the sale and defer that tax into a new investment property.  What you actually do is to do a 1031 exchange and take 50% of the profit as boot and then report the 121 exemption but that's just a tax reporting nuance.  The reality is that you will get 50% tax free and do a 1031 on the other half.

So what can you do at that point?  Again assuming for simplicity that each of your duplexes were identical and sold for the same amount say 200K then you would take 100K as the primary residence exemption and 1031 the other 100K  If you want to combine it with your partner then you would buy a property or properties worth at least $200K (your 100 and his 100).  You don't have to combine with your partner but you can.  Each of you has your own stand alone 1031.  

If the two of you do work together to 1031 both your duplexes into a new bigger investment property then each of you would be buying 50% of the property in your own names (title on your new property has to be the same as on your old property). You could leave this property in each of your names as tennants in common. Or you could contribute the property into a new LLC after the fact and allocate the membership interests appropriately. Once you do that then any future 1031 will need to be done by the LLC that now owns the property. So financing may become an issue.

The bottom line for you is that when you talk to your cpa and attorney you'll want to discuss combining a 1031 exchange with a sec 121 primary residence exclusion.  It'll be the best of both worlds for you.

@Wayne Brooks Wayne is right in what he said. I just wanted to add that you can use a Section 121 and a 1031 together when you have an owner occupied duplex, triplex, etc. Section 121 would apply to the owner occupied part, the 1031 would apply to the rental part. 

@Brandon Hartman The problem I see with your scenario is that you are just trying to make things too complicated. It would be much easier if each of you closed your positions, and picked up a property together in the name of your LLC instead of trying to transfer properties into or out of the entity. When you transfer property into and out of a partnership, you subject yourself to a whole slew of tax problems that can be quite expensive to sift through. Keep it simple in the beginning. There's little point in over complicating everything and spending more money than you have to.

@Wayne Brooks @Dave Foster @Brandon Hall

Guys, thanks a ton for the great insight here.  As usual, it seems like I was over complicating things in my head.

When my partner and I spoke to our attorney initially he said that we might be able to get financing under our LLC as long as we signed as personal guarantors...he did say to speak with our CPA to confirm this though. We are interviewing a few CPAs next week before we select one to move forward with, we will seek their expertise on how to structure our acquisitions to avoid challenges with financing. Is is true that we could get traditional financing under our LLC by signing and personal guarantors on the loan, or was our attorney mistaken?

@Steve Vaughan

Thanks for pinging Bill, I've seen both he and Dave's posts previously regarding 1031's so I was hoping one of them would be able to help set me straight.

@Brandon Hartman You simply can Not get FHA financing, or any other owner occupant financing, as an LLC. An owner occupant must be a natural person. For the vast majority of people, an LLC is an unnecessary burden causing more problems than it solves. Even for an investor loan LLC's are harder to get financing for.

Originally posted by @Wayne Brooks :

@Brandon Hartman You simply can Not get FHA financing, or any other owner occupant financing, as an LLC. An owner occupant must be a natural person. For the vast majority of people, an LLC is an unnecessary burden causing more problems than it solves. Even for an investor loan LLC's are harder to get financing for.

Thanks, Wayne! It seems like our attorney's prediction was incorrect, which is why he told us to clarify with our CPA (previously I had read over and over here that LLC's can't get financing which is why we asked him briefly, since we don't have a CPA lined up yet to ask). Is it any different for a Partnership? If not, how do people typically invest in properties together when it's not just one person signing for the financing?

Originally posted by @Brandon Hartman :
Originally posted by @Wayne Brooks:

@Brandon Hartman You simply can Not get FHA financing, or any other owner occupant financing, as an LLC. An owner occupant must be a natural person. For the vast majority of people, an LLC is an unnecessary burden causing more problems than it solves. Even for an investor loan LLC's are harder to get financing for.

Thanks, Wayne! It seems like our attorney's prediction was incorrect, which is why he told us to clarify with our CPA (previously I had read over and over here that LLC's can't get financing which is why we asked him briefly, since we don't have a CPA lined up yet to ask). Is it any different for a Partnership? If not, how do people typically invest in properties together when it's not just one person signing for the financing?

I think you're confusing something here. An LLC absolutely CAN get financing, and as your attorney mentioned in order to do so you'll be personally guaranteeing the loan.

Wayne was speaking to conventional loans, those an LLC is not able to get. You would be looking for a commercial loan. Financing an LLC is more difficult, but certainly not an impossibility at all. That said I'd still (and actually do for myself) go with the conventional loan route if you can.

@Matt Devincenzo

Correct, I was referencing only conventional financing with all of my questions (I want to avoid commercial financing for as long as possible in our growth strategy). Thanks for the answer.

I think your strategy will depend on the type of property you target. If you target cash flowing rentals in decent shape - you should accumulate some cash during your holding period. I would use this for the next step - the LLC investment.

Unless you successfully upgrade the property with major renovations, your gain on the sale will likely not warrant the complexity of using a 1031 exchange.  You will have a couple years of recapture taxes to pay and capital gains.

If you are looking at a 20% gain on a 100K property - a 1031 will defer about 4500 in federal taxes(3000 for depreciation and 1500 for capital gains).  You would have to defer them about 4 years for a 1000 in 1031 fees(which may be low) to pay off.  A longer holding period on the property will increase the value of the 1031.  I think planning for a 4 year holding period and a combination of 121/1031 maybe the best strategy, but I would be flexible based on how things are going and what the rental and selling markets look like.

@Jesse T.

That is a great point. We were originally looking to size up after year 3 (i.e. after 2 years of holding the two FHA properties) but you make a great point that we may be better served to stay patient and continue holding them. We do intend to make significant renovations inside of the properties while occupying them since we plan to purchase discounted duplexes in the nicer area of downtown and can command higher future rents/appraisal with high quality finishes (how much we update will depend on the point of diminishing returns in terms of rent and property valuation). I think our decision will really come down to which scenarios numbers make the most sense -- as it is currently written in our goal statement, we would sell and size up, but that could very well change if the numbers say we are better off holding the properties for a few additional years. If we do hold there is always the opportunity to cash out refi it to pull some cash out for expansion in the acquisition of other properties. Lots of variables in play here.

When we move out of those first two FHA properties, regardless of if we continue to hold or we sell, we intend to do it once again with two new properties for two additional years. Our end goal is to be able to 1031 exchange all of our existing holdings and acquire a commercial property after year 5 (we would only be through one year in the new FHA properties, so they will not be exchanged)....but as I said above, that could change depending on a number of different things.

I wanted to clarify a point here. You currently own the properties as individuals, so each of you are the "taxpayers" for 1031 Exchange purposes. It is important that the "taxpayers" remain the same throughout the 1031 Exchange. You can each 1031 Exchange into the same property, but you must acquire individual interests as tenants-in-common (not through the limited liability company). Buying through the LLC would be deemed a purchase of a partnership interest and not a purchase of a real estate interest. I would also be very careful as to how soon after the completion of the 1031 Exchange you contribute the combined property into the LLC. The critical issue is your intent to hold for investment purposes in order to qualify for 1031 Exchange treatment. The purchase of the property and an immediate contribution into an LLC could result in the disallowance of the transaction as a 1031 Exchange since it would be a deemed purchase of a partnership interest. There are ways to do it, so consult with your tax advisors first before you proceed with any contribution into an LLC.

@Bill Exeter , thanks for the helpful response! This all makes sense now and I believe that we will be avoiding a LLC until we are scaled up enough to warrant it (and we will be sure to cover this with our tax team prior to ever making any moves).

All of the information from this thread will be great knowledge for me to have going into the discussions with our CPA and attorney on how to structure our business.