Tricky 1031 exchange w/ condo conversion

[John Pauler]

Here's a 1031 challenge I am currently going through now...

In March 2014, I purchased a small two family owner occ with a tenant renting the other unit.   

In August 2014, I moved out and have been using it as an investment property ever since. 

Now both of my tenants are interested in purchasing their units, so I am thinking it is a good time to turn it into condos (was physically condo-ready when I bought it, so it is just legal/paperwork), create some value, and re-invest in a larger property. 

I would like to use the 1031 exchange (this would be my first time doing so, total novice here) to avoid paying capital gains and depreciation recapture, but I cannot figure out if this would apply to my situation since I am technically selling the property as two separate transactions. 

Does anyone have experience doing something similar? 

Any advice? 

Thanks! 

John

[Dave Foster]

@John Pauler, You would probably end up treating it like two exchanges but it's pretty straightforward and should work just fine.  Your new condos will each have a legal description.  Each contract to sell would contain the new legal description and be underwritten with title insurance on it's own.  We would use that contract and title issuance to craft your exchange documents.  There is some need to keep an eye on establishing intent to hold due the fact that you are actually creating two new pieces of real estate.  But that is easily overcome.

Once you start each exchange, each will have it's own calendar for identification and completion but there is no reason why you cannot schedule your closings such that you could easily combine the two exchanges into one purchase.

Example - If you sell each side for $150K you would need to purchase 150K to complete each exchange.  But with proper timing you could put the two of them into one 300K property and that would work just as well - a consolidation exchange.  Or keep them separate with their own replacement properties.  Either way you accomplish just what you want - deferral of tax and depreciation recapture.

You've got a lot of options.

[John Pauler]

@Dave Foster, I appreciate your response. I saw your name come up a number of times within the 1031 exchange forums when I started my research, and you really seem to have mastery of the subject matter. 

For some reason I had it in my head that the conversion to condos would make me ineligible for 1031 exchange on their sale. My understanding was that the creation of the two condo units is an event seen by the IRS as being done for a "resale" purpose (not for hold investing purposes) which makes it ineligible for the 1031, and that the actual sale of the units was a second event from the perspective of the IRS, only occurring after the "resale" event which triggers my tax liability. Is that not the case? Maybe I am making too much of this? 

Thanks for your thoughts!

[Dave Foster]

@John Pauler,  Nah it's not just in your head, the perception of the creation of real estate with the primary intent to resell is as I mentioned, a slight but potential issue.  However, another interpretation is that, you are simply creating a more accurate identification of the property that you purchased to hold for productive use as evidenced by your actual use and the two rentors.  In fact, your original intent March 2014 was mixed use primary and investment.  In August of 2014 you changed that intent to totally investment and now for the past two years have been demonstrating your intent to hold for productive use for this particular piece of real estate regardless of it's legal description.  

In order to once again change your intent it would be prudent to make the property as saleable as possible.  You'll certainly want your CPA's blessing but most agree that changing legal entitlements alone with the end of creating a best and highest use for a piece of investment real estate falls short by itself of the thresh hold of showing previous intent

You could complete your condo conversion and then rent for a further bit of time while giving your tenants a ROFR or option.  Or your CPA might feel comfortable with whatever adjustments they make to your Sched E.  

[John Pauler]

@Dave Foster, this makes sense. Planning to have a conversation with my CPA later this week, and I will go over everything with him then to confirm the strategy. 

I really appreciate your perspective on this. Thank you!

[David Krulac]

@John Pauler

It could be either one or two IRC 1031s.  You can have multiple relinquished properties as well as multiple acquired properties.

I have actually done a condo conversion on a small apt building.  And I did not re-sell either unit yet, after 9 years.

A bigger question for me is what requirements are you going to need to go through to finalize the condo separation? I've done subdivisions in multiple states and the procedure while similar is different in different jurisdictions. In the states where I've done condos, the rules are like doing a subdivision; and you need certain number of off street parking spaces, maximum impervious surface, and you need the zoning that allows multiple units. different jurisdictions view grandfathering differently and may not permit a condo conversion in a zoning for SFH for example.

The condo docs need to be drafted and meet state regulations.  In many jurisdictions the regs for 2 units could be the same as doing 200 units.  The attorney fees for condo docs will be thousands, and then you still need municipal and/or county approvals, and hearings.

One item that was required for me was that I needed interior survey and blueprints for a 1902 building which didn't have any blueprints.  They required an exterior survey.  costs even for a 2 unit were were around $10,000. just to be able to present case to the government authorities. 

[John Pauler]

@David Krulac, good to know you can do it as two IRC 1031s. I will speak with my CPA about that option. Thank you! 

RE: the complexity required in conversion, even for a small apartment - you are 100% correct. In Somerville, MA, where I am converting, the rules are very strict. They require everything you mentioned, and even have some additional requirements...separate water, electric, and heating systems and meters, and a structural engineer or architects "statement of condition" for all the systems in the building...not cheap. $10k total costs would be nice. My conversion costs going to run North of $12k all-in. 

[John Pauler]

@Dave Foster, @David Krulac, thanks a lot for your help on the 1031! It has been very helpful, and encouraged me to move forward. 

A couple of additional questions have come up as I have thought through this. Would love to hear your thoughts or anyone else's who consider themselves 1031 experts or at least 1031-educated. Here goes...

1) the 1031 exchange requires you to re-invest all cash proceeds from your sale into the next property. Are there any rules about refinancing to pull some cash out at some point in the future? 

2) what are the rules about exchanging into a single member (just me) LLC? I am at the point where I should start protecting my assets with these entities, but the property I am selling is the first 2F I ever bought, and was purchased in my name, not in an LLC.

Any help with these are greatly appreciated! 

[David Krulac]

1.  you can refi anytime, borrowed money is not taxable income.

2. my understanding is that the relinquished owner must be the the same as the acquired owner, except for TIC

[Dave Foster]

@John Pauler, A single member LLC is probably going to be a disregarded entity for tax purposes if you choose for it to be taxed that way. If it does not file it's own taxes but all activity of the LLC is reported on your personal return then for IRS purposes you and the LLC are the same taxpaying entity regardless of who is on the deed. You can sell as yourself and buy as your LLC or immediately contribute it into your LLC or sell as your LLC and buy as yourself. This last is far more common because of the difficulty in obtaining financing in the name of an LLC.

You may refinance your property after the exchange to gain access to any cash that you may have wanted to pull from the exchange.  @David Krulac is correct.  Accessing cash this way does not create a taxable event.

[John Pauler]

@David Krulac, @Dave Foster, very good information here from both of you. Thanks for the help! (...again)