How can I keep my property but take advantage of gains exclusion

Question

I purchased a 4-unit property eight years ago that has over doubled in value. I joined the military so I have up to 10 (vice the normal 5) years to sell and have capital gains excluded since I lived in the property for 2 years.  I am wondering if there is any way to sell the property to myself (to some sort of business entity like an LLC) so that I can "cash out" my equity tax-free (before that 10 year mark) and then have a new property basis in whatever entity that owns the home. I could just straight up sell the property but it has been such a great investment that I don't really want to get rid of it. Thoughts or experience? Thanks!

Dave Toelkes · Answer

@Janine Badic,

There is something you have overlooked.  The Section 121 capital gains exclusion only applies to the unit you occupied as your primary residence.  The sale of the remaining three units would be a taxable event.

To avoid the capital gains tax on the sale of this property, you should explore a 1031 tax-deferred exchange to defer capital gains taxes (perhaps indefinitely).   The 1031 exchange can be used to roll over your capital gain into the acquisition of a replacement property.  If it turns out that you aren't eligible for the section 121 exclusion, you can use the 1031 exchange to defer capital gains taxes on the sale of the entire property.

Check with your base legal aid office, or a licensed tax advisor about your status with regard to the section 121 exclusion.  Just being in the military may not automatically grant you a five year extension on the 121 exclusion...some extended period of overseas deployment may be in the mix.  If your section 121 eligibility is still intact, then when you sell the proprety, you can use the section 121 exclusion for your former residence unit, and use the 1031 exchange for the remaining three units.  In this instance, you will have to pay tax on the unrecaptured depreciation for your residence unit, even though your profit due to appreciation may be excluded.  Or, you can just decide to use a 1031 exchange for the entire property to roll over the capital gain and all the depreciation into a replacement property and have a tax free event.

Janine Badic · Answer

Thanks for the info and thoughts.   I actually had not even considered that I may only be exclude 1/4 of the capital gains since it is a 4-unit... in which case I am not sure it would even be worth going through the hassle of restructuring the ownership of the property.  Good points all around.   I appreciate everyone's insight.

Christopher Smith · Answer

The S Corp sale mechanics are from IRS Letter Ruling 8350084 which is based upon old IRC 1034. That is no longer current law, but as I indicated above this ruling may give you an idea of what is possible.

Remember that in addition to being based on old law a private ruling is only binding for the person that it is issued directly to, not the public at large. So you take some element of risk relying upon it unless you go to the time effort and expense of requesting a ruling in your own capacity.

One final caveat, it sounds as if this property would only be partially eligible for home exclusion treatment (since apparently only part of it was your princ res) which may create a number of other potentially unfavorable tax issues not to mention the usual issues of having a corporation (even an S Corporation) owning the property.

Lance Lvovsky · Answer

@Janine Badic You could sell the property to an S Corp that you own, and get the Section 121 gain exclusion. I would discuss this with a CPA, as you want to make sure the transaction is structured carefully. Keep in mind, by doing this, you will get the capital gains exclusion, but the real estate ends up in a Corporation - which is not ideal. Of course there are ways in the future to get the real estate out of the Corporation.

David Barnett · Answer

@Janine Badic  I think I'm on the same page as Christopher.  It sounds like you're trying to do some creative maneuvering of the owner of the property to skirt taxes, which is probably not a good idea.  Although I'm not a tax person, I would venture to guess that the Internal Revenue Service wouldn't look upon this situation too kindly.  I'm assuming you don't live in any of the units currently?  Why not do a cash out refinance to pull out some of the equity and then move back into one of the units within the next two years to reset the 10 year clock?  I believe you're referring to the living in the home for 2 of the past 5 years (in your case 10 due to military service) to exclude capital gains?  My understanding of that exclusion isn't having to sell the property within the timeframe, just having to live in the property for 2 out of the previous 10 years.

Christopher Smith · Answer

You can explore the case law and Govt rulings in this area of the tax law. That might give you some ideas of what is possible and what is not.

However the very nature of your question seems to indicate that what you would like to do contravenes the purpose of the statute which likely means the Service would go the extra mile to enforce the letter of statute against you, and if that were insufficient invoke substance over form anti abuse provisions to prevent you from accomplishing what you desire.

How can I keep my property but take advantage of gains exclusion

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