Question about a potential 1031 exchange

[Jason Pritchard]

Hey Everyone,

I'm looking for some advice on how to best defer capital gains taxes on my next fix and flip project. I'm partnering up with my brother in law to flip a house that he owns but has been renting for just under 2 years. He purchased the home in 2010 and lived in the residence for 3 years prior to moving and renting it out, he is currently renting the home he lives in now and owns no other property. We have started the process of forming an LLC and I am currently working with a friend who is also a RE attorney to help guide me on the proper formation of the business. Here's what I would like to know:

Option 1 would be to transfer title of the home into the LLC's name, fix and flip the porperty, and do a 1031 exchange to defer capital gains? I have spent some time on this forum and also online researching the ins and outs of how a 1031 exchange works so I am somewhat familiar with the process.

Option 2 would be to keep title in my brother in laws name and since this was his primary residence for 3/5 years have him sell the home without having to pay capital gains (at least this is my understanding of how the law works). I would work with my attorney to make sure that all the legal paperwork is in place to prevent this deal from getting sideways on me.

I do understand that that there is more risk with option 2 since I would not actually be on the titile of the property but I do like the idea of having access to our profits right away without being forced to adhere to some of the guidlelines within a 1031 exchange. I am open to any thoughts or opinions that you may have, thanks in advance for the help!

[Dave Foster]

@Jason Pritchard 

Your options are surprisingly limited on this first transaction.  First thing you need to do though is eliminate the words fix n flip from your vocabulary.  When you fix n flip your intent from the day you take title to the property is to sell that property.  That is precisely the behavior prohibited if you want to do a 1031.  In order to be eligible to do a 1031 your intent must have been to hold the property for productive use in business trade or for investment.  By renting that property for 2 years your brother has demonstrated that intent so he could do a 1031.  But if you put yourself on title you would be seen as doing so in order to flip the property so no go on the exchange.

In my opinion the biggest advantage would come from your brother selling the property and taking the sec 121 primary residence exclusion.  He actually only has to have lived in it for 2 out of the previous 5 year period and the gain up to $250K if he's single or $500K if married would be tax free.  Because he has operated it as a rental he would have to recapture the depreciation taken during the time as a rental.

By doing this you avoid the potential entanglement of demonstrating intent on a 1031 and you avoid the cost of a 1031 all together. Your brother can just as easily contribute cash into the LLC you form and then you can be off the the races - just not fix n flipping if you want to do 1031s.