This is the second of a four-part series of Questions and Answers related to entity structuring.
QUESTION: A few years ago I entered into a partnership with my brother and a couple of friends. We purchased a single-family house to rent out. We (over)paid around $127,000 for the house. The property is titled in my brother’s name, as is the mortgage on the property, with a current balance of $102,000. A few years back, as the partnership began to lose money, I bought out two of the partners. I now own about an 80% interest in the partnership.
I would like to buy out my brother’s interest so that I can eventually either sell the house utilizing a 1031 exchange or re-finance the house at current low interest rates (I can qualify for a conventional mortgage). I don’t want to sell the house out of the partnership and get stuck paying depreciation recapture. The house will sell for $130k – $135k.
In order to do a 1031 exchange or refinance the house, I need it to be deeded in my name. Can I buy my brother’s share of the partnership and then have the partnership deed the house over to me without triggering any tax consequences? Will the partnership (a general partnership, we never filed formation documents with the secretary of state) cease to exist if I buy out my brother’s interest? Will there be some seasoning period required, or should I be able to re-fi right away if I acquire 100% of the partnership?
ANSWER: The partnership can certainly sell relinquished property held in the entity’s name and then purchase like-kind replacement property to be held by the same entity, which still qualifies for 1031 Exchange treatment. So even if it is owned just by you or you and your brother, you can still do it in the name of the LLC. Now if you need to refinance then you would need to deed it out of the LLC back into your name. You can certainly buy your brother’s share in the partnership and then transfer the property into your name. There is no seasoning requirement or tax consequences except that your brother may have a gain or loss on the sale of his partnership interest to you. Please keep in mind that whether you sell the property in your name or in the name of the LLC, there will be depreciation recapture except you are saying not having depreciation recapture since you are going to do a 1031 exchange.
QUESTION: Growing our RE business in the US certainly has its growing pains. In structuring our entities, (we function in Florida, Georgia, and soon in Texas), we have been informed that “…your company is a dealer in real estate sales and purchases, not an investor (1031 exchange tax deferral is not allowed for dealers)”.
How are your 1031 exchanges handled? Is this an entity-focused restriction, or an activity-focused restriction? I see the reasoning on an individual basis, but how many flips does it take before you are considered a dealer?
ANSWER: It all boils down to intent. If your intent is to buy, fix, and flip then you are a dealer and cannot 1031 exchange. If your intent is to Buy, and hold but then decide to flip, then you can 1031 exchange and there is also a holding period requirement when next you want to sell the replacement property for another one. Most people usually recommend 12-18 months but if you are flipping within a short period of time, then you are a dealer and subject to S.E. tax. You could come up with an entity structure that minimizes not eliminate your Self Employment taxes
QUESTION: If I form an LLC in New York can I do business nationally without forming another LLC in other states? If so, what is my tax liability?
ANSWER: Yes you can but I usually suggest that it is better to register the NY LLC in the state where you are located as a foreign entity if you have properties to buy and hold. For tax purposes, you would have to pay taxes in the states where you earned income. This may not necessarily be an issue if your business is focusing on wholesaling and rehabbing not holding properties.
QUESTION: I have been advised to form an LLC in Nevada or Delaware, but I invest in Philadelphia, PA, and live in New York. How does this help or hurt me with taxes?
ANSWER: I do not believe in forming an LLC in a state where you do not operate. If you get sued, it is the local laws that govern and although I have heard that some states are more friendly when it comes to charging orders, there are other strategies such as having a Multi-member LLC that can mitigate that concern. The most important state for you would be PA in terms of forming your entity. Also, keep in mind that putting property in an LLC may protect you from the bottom-up creditor (meaning the ones that come after you personally) but may not protect you from the top-down creditor (the creditors that come after the property directly), especially if there is equity. So you need to ensure that you take into account proper asset protection strategies.
I address many of these issues in my Wealth Building Plan. Make sure you are getting the best tax advice. Let me evaluate your financial and tax situation, then develop a customized tax strategy just for you. Together, we will come up with a strategic plan designed to answer your questions as you build your own customized wealth-building plan. You can get more information at Wealth Building Plan.
