Section 1031 conversion 2 properties for 1
My brother owns the following:
33% of a single family rental home and 50% of a townhome.
Q1>I own the other 50% of the townhome which we currently rent out. I want to move into this property and first just pay rent at FMV to my brother. Will he still be allowed to file a Schedule E and get the same benefits as if he was renting to a third party? Would this afford him any tax consequences or additional filings?
Q2> He wants to purchase another residence and sell out of both his 33% share and 50% share and purchase another property at a 100% stake. Will sale of 2 properties and a purchase of only 1 qualify for Section 1031 deferral of the gains? Assume both his current market value in both properties that he currently owns are 75k and 75k and that his current cost basis is just 5k and 10k as they are both fully depreciated (original cost of 35k and 40k). He wants to purchase a rental single family home for 200k using the proceeds of the 2 sales (150k) and financing the additional 50k. Would he have any taxable event on these sales(both properties purchased in 1985) if he purchases the new rental property? Also, what forms would need to be filed. Another question is he has NOL carryforward on both these of 10k and 15k would he still be allowed to use and carryforward these NOL's against the new property?
Q3> He wants to be able to finance more than 50k of the new property and I believe that would have a taxable consequence as he would be gaining cash on the transaction. Am I correct? What if he used the proceeds to do improvements on the new property could he then finance more than 50k or could he take a home equity loan after the original purchase to finance improvements?
Q4> What would the new properties depreciable basis be (assuming the land is valued at 30K)? I assumed that it would be only 40k (the 200k cost less the land of 30k less the 140k of deferred gain on the 2 sales). Or would depreciation recapture of the 60k effect this number and his current taxes? Or would the NOL carryforward of 20k effect this number?
Once again. I am indebted to your wonderful advice. Thanks so much.
My brother owns the following:
33% of a single family rental home and 50% of a townhome.I own the other 50% of the townhome which we currently rent out. I want to move into this property and first just pay rent at FMV to my brother.
Q1a. Will he still be allowed to file a Schedule E and get the same benefits as if he was renting to a third party?
Answer: Yes.
Q1b. Would this afford him any tax consequences or additional filings?
Answer: No, because the property has not been sold, a taxable event has not occurred. He still gets the "tax shelter" of a rental property as before. I assume that you will be renting only his half of the property and your FMR will be prorated accordingly.
Q2a. He wants to purchase another residence and sell out of both his 33% share and 50% share and purchase another property at a 100% stake. Will sale of 2 properties and a purchase of only 1 qualify for Section 1031 deferral of the gains?
Answer: Yes, two investment properties may be exchanged for one investment property in a 1031 tax-deferred exchange.
Q2b. Assume both his current market value in both properties that he currently owns are 75k and 75k and that his current cost basis is just 5k and 10k as they are both fully depreciated (original cost of 35k and 40k). He wants to purchase a rental single family home for 200k using the proceeds of the 2 sales (150k) and financing the additional 50k. Would he have any taxable event on these sales(both properties purchased in 1985) if he purchases the new rental property?
Answer: No. Assuming that all the 1031 requirements are met, the sale of the relinquished properties and the purchase of a replacement property is not a taxable event. However, if the properties actually sold for $75K each, your brother's share of the sale proceeds would $25K (33% of the first property) and $37.5K (50% of the second property), for a total of $62.5K. Your brother would only need to purchase a $62.5K replacement property for a valid 1031 exchange.
Q2c. Also, what forms would need to be filed.
Answer: Form 8824, "Like-Kind Exchanges", in addition to all the other forms normally filed with his return.
Q2d. Another question is he has NOL carryforward on both these of 10k and 15k would he still be allowed to use and carryforward these NOL's against the new property?
Answer: Suspended passive losses from the relinquished properties will be used to adjust the depreciable basis in the replacement property.
Q3a. He wants to be able to finance more than 50k of the new property and I believe that would have a taxable consequence as he would be gaining cash on the transaction. Am I correct?
Answer: No. As long as all of the proceeds of the sale of the relinquished property is applied to the purchase of the replacement property, adding new financing to fund the purchase is not a taxable event.
Q3b. What if he used the proceeds to do improvements on the new property could he then finance more than 50k or could he take a home equity loan after the original purchase to finance improvements?
Answer: If your brother "takes" any of the proceeds from the sale of the relinquished property, then he has constructive receipt of that money. That money will be excluded from the 1031 exchange umbrella and taxed accordingly.
If there is enough money in the exchange escrow account, there is a way for the qualified intermediary to fund rehab from the escrow account before title transfers to your brother. This may make the exchange process more complicated than necessary, when just getting an equity loan after the exchange is completed would work just as well.
An even easier approach, would be to do a cashout refinance on one of the properties to be relinquished before entering into the 1031 exchange. Now your brother has cash in hand to fund improvements to the replacement property, with no taxable consequence.
Q4. What would the new properties depreciable basis be (assuming the land is valued at 30K)? I assumed that it would be only 40k (the 200k cost less the land of 30k less the 140k of deferred gain on the 2 sales). Or would depreciation recapture of the 60k effect this number and his current taxes? Or would the NOL carryforward of 20k effect this number?
Answer: In a nutshell, the cost basis in the replacement property is the basis in the relinquished property plus any new money needed to fund the deal. You said that the current basis in the relinquished properties is $15K ($5K and $10K). If $50K of new money is added to the deal to complete the purchase, then the new cost basis is $65K. If $30K of this basis is the value of the land for the replacement property, then the depreciable basis of the replacement property improvements is only $35K. With better arithmetic, you would have gotten the same answer with your approach except the deferred gain is only $135K ($150 sale price minus $15K current basis in the two properties leaves $135K in deferred gain, so, $200K purchase price minus $30K land value minus $135K deferred gain leaves $35k for depreciable basis). Of course, in actual practice selling costs would be considered in your computations. Any suspended passive losses from the relinquished properties would be added to this new basis, too. If your brother has $20K in suspended passive losses, then in this example, the new depreciable basis would be increased to $55K.
Depreciation recapture does not come into play until the replacement property is sold outright -- that is, when a taxable sale occurs.
Hope this helps. Do a web search for "1031 exchange". You will get hits for several exchange facilitators that will happily mail you free literature explaining the entire process.