Q: My brother, my sister, and I own a residential lot as an investment that our parents put in our names years ago. We each own one-third of the lot.
We signed a contract to sell the property and when it closes, my brother and I are looking into purchasing a mountain lot for a future cabin. We probably wouldn’t build on the lot for 5 to 10 years, so for now, it would just be another investment property.
Would a 1031 tax-free exchange apply to this situation? The lot might ultimately be used to build a vacation home and we would not plan on renting it.
I am also wondering about the wisdom of investing with my brother. I have read articles on “beware of investing with friends and family” and I want to be smart about this (as does my brother).
Is there a smart way to create a partnership between us from a legal standpoint? Should we open up a Limited Liability Corporation (LLC), a joint bank account, write a partnership agreement, or hold title as joint tenants with rights of survivorship?
A: You’re wise to ask these questions now, before you close on your existing investment property. Once you close, it may be too late. A 1031 tax-free exchange allows you to sell your current investment property and purchase another investment property. The reason you’d do a 1031 exchange is that it allows you to defer any taxes owed on the sale of your investment property. You still owe the tax, but it’s rolled over into the purchase of the new property, which must cost at least as much as the property you’re selling.
If you want to do a 1031 exchange, you’ll need to talk to a real estate attorney quickly, in order to set it up. Or, you can work with one of the many well-regarded 1031 companies. The 1031 company will act as a neutral third-party and hold the cash from the sale until it is rolled over into next purchase. Many of them have web sites with great information that can assist you in planning your sale and purchase when using a 1031 exchange.
When you use a 1031 exchange, there are strict rules you must follow. If you miss a deadline or fail to follow the requirements, the 1031 exchange will fail and you will have to pay the taxes. That’s why it’s a good idea to follow up with this now and make some decisions about what you’re going to buy.
If you sell your current investment property you must buy a replacement investment property. You must intend to use the replacement property for investment purposes. You should consult with a real estate attorney or other 1031 specialist to get more information on the requirements for your replacement property and whether it qualifies.
As for investing with your brother, the smart move is to have the same real estate attorney you consult for help with the 1031 exchange draft a partnership agreement that spells out the terms and conditions of your business relationship.
A good attorney will ask you what happens if you or your brother wants to sell but the other partner does not. Who can back out of the deal and how? What if you want to buy out your brother’s interest in the property? How will you calculate the profit (if any), tax liability and other expenses? Who will pay to maintain the property and whose responsibility will it be to get the tax bill each year and make sure it’s paid?
If you decide to build on the land, who will put up the cash and how will you divide the use of the space?
These are all important questions for you and your brother to answer and I encourage you to talk about it before you complete your purchase. Once you answer them, your attorney can advise you on how to hold title, whether you need an LLC, and other legal issues.