Do all partners have to do a 1031 exchange? Can you do a 1031 exchange on jointly owned property? A trio of siblings wants to know how to do a 1031 exchange if only two of the three siblings are on in the deal.
Q: I hope you can answer this question for me. We have consulted three lawyers and two accountants and no one agrees on the answer.
My brother, sister and I own a home with almost seven acres of land. We inherited it from our father. Then we formed a limited liability company (LLC) to manage the rental of the house. We’re now preparing to sell the property, and the contract is being reviewed by the buyer.
All partners don’t want to do a 1031 exchange
Two of us want to take the money and the other person wants to do a 1031 exchange. Do we all three have to agree on this part? Also, how do we calculate the capital gains tax that we might owe? We have been offered $2,000,000 for the property.
A: You’ve consulted with five professionals and still haven’t received the answer you’ve been looking for? Okay, we’ll give it a shot.
Let’s start with what happens when you inherit property. As we’ve discussed in prior columns, when you inherited that property, you received it at its market value as of the date your father died. So, even if he bought it for $100,000, if it was worth $2 million when he died, that is the stepped up basis for tax purposes.
But did he die a year ago or 30 years ago? Is the property fully depreciated? The answers to these questions directly impact the tax you’ll owe. We’ll get to those questions in a moment.
1031 Exchange allows you to defer taxes when selling an investment property
A 1031 exchange allows real estate investors to defer federal income and capital gains taxes when selling investment real estate property. Essentially, you buy a replacement property that costs the same or more than the property you’re selling. You have to complete the purchase and sale within a tight timeframe. The name comes from section 1031 of the Internal Revenue Code. We’ve written about the general rules of 1031 exchanges over the years.
In your case, the limited liability company could sell the property and then would then have to buy a replacement property that costs at least $2 million to defer federal income taxes on the sale of the investment property.
But here’s the rub: Two of you want to keep the cash generated from the sale and one wants to defer any taxes owed.
Is an LLC involved? It will have to do the 1031 Exchange
If the LLC sells the property, the LLC is the only entity that can undertake the 1031 exchange. In this situation, it would be all or nothing for the company. Having said that, the LLC may distribute the property prior to sale to the members and each member could then sell their interest in the property to this buyer.
Let’s say each of you owns one-third of the company and each of you conveyed the one-third interest to the buyer. One sibling could sell their interest to the buyer, set up a 1031 exchange intermediary and follow the 1031 rules to buy a replacement property. That sibling should be able to defer federal income and capital gains taxes through the use of a 1031 exchange and the other two siblings would simply sell their share of the property and pay whatever taxes they would owe to the federal government.
Make sure you talk to an expert in 1031 exchanges to walk you through the mechanism you’ll need to go through to distribute the interest in the property from the LLC to its members.
Use a 1031 Expert to Help
How much would you pay in taxes? You didn’t give us quite enough information for us to even do a back of the envelope calculation. Suffice to say that you and your siblings inherited the property at whatever value the property had at the time of your father’s death.
But, here’s how to think it through: Start with the date of your dad’s death. If the property was worth $1,500,000 when he passed away and you’re selling it for $2,000,000. It’s easy to say you’d owe tax on the difference, $500,000. But this is an investment property. We don’t know if you and your siblings put money into the property (or how much). We don’t know how long you’ve owned the property. Or how much depreciation you took over the time you owned the property.
If you inherited the property 30 years ago and have now fully depreciated the property, you may have a significant tax to pay for the recapture of the depreciation (at a rate of 25 percent of the amount depreciated) and for the capital gains. Go back to one of the accountants for answers. Choose someone who has substantial knowledge in the area of federal taxation of real estate, depreciation and capital gains.
Missing 1031 Deadlines Could Spell Trouble
Talk to a person that works at a tax deferred exchange company that specializes in 1031 exchanges. However, you should talk to someone with a lot of experience. Your situation is complicated. If you do it wrong, you could run afoul of the many rules that govern 1031 exchanges and wind up with a huge tax bill, with penalties.
At the end of the day, we think it’s possible to divide ownership and then allow two of the siblings to pay any taxes owed and pocket the remaining cash while the third reinvests their share of the proceeds. But once everyone sees just how much tax they’ll owe, everyone may be more interested in reinvesting those proceeds into a real estate investment structured to provide income over the long run.
Read more about 1031 Exchanges
1031 Rules and Limitations
1031 Exchange Process, Timelines and Examples
How to Sell Your 1031 Exchange Inheritance
1031 Exchange Deadlines During COVID-19 Pandemic
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