How can we 1031 a joint tenants 2-unit into an LLC 3-unit?

Question

My partner and I have owned a 2-unit in SF, as joint tenants, since 6/13 (we were tenants from 1999.) We began renting our second unit 11/15, to a family member, but legit—with actual monthly checks paid to my partner and deposited in his rental account. Only he earns income and files taxes, so he is the only taxpayer that’s ever been associated with the property. We have not yet filed for 2015/2016. (We did not know if we wanted to condo convert the building and if we had, we would have wanted the prop to reflect 100% owner occupancy, thus no filing until we decided which path to pursue.)

We have been interested in a 3-unit in Hawaii since 1/17. We flew out to see it out in January and were ready to make an offer when we got news of a family situation that took precedence. The Hawaii prop went into escrow with another buyer. We became ready to make an offer again after the Hawaii seller's first offer fell out of escrow. The day before that offer was going to be submitted, I was served with a summons for a lawsuit related to comments made on Facebook about an alleged sexual predator in my community. Once again, we were forced to table our offer on the Hawaii prop and, once again, it went into escrow with another buyer. My lawyer has now assured me the case should be dismissed but says, even if it isn’t, I need to proceed with living my life. So, we began looking at other Hawaii props, but then the one we’ve been dancing with for a year was relisted earlier this week—after having fallen out of escrow for the third time since January. So, we are now looking at options for proceeding and trying to guess at how the tax bill may impact our options and choices.

We'd previously discussed with an accountant the ability to bifurcate SF's gains to utilize both Sec 121 cap gains exemption and a 1031 exchange. But we were told placing the prop into an LLC would eliminate the Sec 121 option for us, so we have not done that.

I’m seeing the tax bill may take away our Sec 121 eligibility unless we stay in the prop until 6/18 (five years ownership & occupancy), but I’m wondering if occupancy as a renter prior to ownership would qualify us if we sold prior to 6/18? Or, does the occupancy clock only start when ownership begins?

– If it is going away, then there is no reason (that I can think of) not to put the SF prop into an LLC
prior to selling, correct?

The SF 2-unit is held as joint tenants and we are not married. We want to do a 1031 exchange. We would like to hold the Hawaii prop in an LLC, but we know ownership on both props must be the same.

– Is there a way to do that if my partner has been/will be on the 15/16/17 yet-to-be-filed taxes the
sole tax=payer/entity? We can get married. Or I can quit claim to him. Are there other options?

The urgency around all of this; the Hawaii prop unexpectedly coming back on the market and being told other offers are expected on Saturday, trying to guess at what the tax bill may or may not change, and trying to figure out things like placing the SF prop into an LLC prior to the year's end, all before submitting an offer, never mind ensuring we have access to the funding we'll need for the reverse 1031, is definitely weighing on me. We are not investors with years of experience under our belts. We got very, very lucky four years ago when when the opportunity to purchase our long-time rental apartment presented itself. So, we are doing our best to maximize our opportunity and turn that grand luck into something bigger and better, but there is certainly a bit of terror around knowing there is plenty we do not know and likely even more we do not know we do not know. ;) Any insight, clarity, advice, assistance you can offer, will be greatly appreciated.

Lynn Leigh · Answer

Thanks again @Dave Foster, I just spoke with my accountant and we agreed that trying to move the SF prop into an LLC prior to selling is not necessary for the results I'm trying to realize. I appreciate your thoughts as they helped me work through some of my own and come up with some alternatives.

Lynn Leigh · Answer

Again, thanks Dave for the quick and thoughtful reply. I have a couple of thoughts and would like to see if I can get some clarity around them. Regarding your last point, we have been assured by a CA CPA who specializes in real estate that the 121 is available to us. I am not concerned about that. Regarding your other points: • The preference was always to take advantage of the dual opportunities via bifurcation. I am only considering this LLC question in consideration of the 121 potentially going away right now when we need it. If we lose the 121 option and are forced to wait until June to sell our SF prop, we will forgo the option if it means losing the Hawaii property. If that looks likely, we'd want to get as much of a tax advantage as possible from placing the prop into an LLC and if the tax bill is going to drop the tax rate to 15% for LLCs, well, that's an advantage over being taxed on the sale gains at my and my partner's personal rate. (There is also the benefit of privacy afforded by using two DE LLCs to hold property (one holds property, the other is the manager of the property-holding LLC.) We had already set up two DE LLCs earlier this year in order to do this for a business we were starting but didn't.)• All that said, we did want to do a Reverse 1031, so we would be securing the Hawaii prop before selling our SF prop. If we closed on Hawaii in January, June would be six months away. If we could make holding the SF prop work financially, then taking both the 121 and the 1031 would still be an option, in June when we've hit 5 years of occupancy. But it seems dangerous to try to time that perfectly so that we get the full 5 years by waiting until June, but then also having to sell in June in order to be within the 180-day 1031 clock. Which is why, not trying to hold out for the 121 to work seems the safer bet if it looks like Congress is seriously going to change the occupancy criteria. As to your point here: "It is risky to sell a property right after changing entity and 1031 it. There are issues of intent of the entity if it obtains and immediately sells and then 1031s" How long after placing the prop into an LLC would a 1031 not be risky? Would it matter if we placed the prop into the DE LLC we set up earlier this year to hold the building? Would waiting 6 months from the day it's placed be long enough? Since we are doing a reverse 1031, we could place it into the LLC this week, likely not close on Hawaii until mid-January (maybe later if the sellers are amenable), and then hold off on selling SF until several months had passed, up to that 180 day mark. The reason I was asking about my partner being the sole taxpayer and the LLC either being single owner or he and I getting married and filing jointly was because of what i read below yesterday, which gave me the impression those things would work in our favor. I read this: "One last ownership issue I should mention: certain entities that are owned by a single person are disregarded—they don’t file a tax return and the income and expenses from the property are reported in the tax return of that sole owner. For example, if Sue Jones holds title to her investment property in Jones Investments, LLC, and Sue is the sole owner of Jones Investments. Jones Investments does not file a tax return; Sue reports the income and expenses in her IRS Form 1040. That means Sue herself is the taxpayer that owns the old property and she could sell it, do an exchange, and buy the replacement property in her own name (because it’s her tax return)." here: (https://www.expert1031.com/articles/2014/04/16/look-ownership-issues-1031-exchange)*Thanks for bearing with me on this. My accountant was not available to talk until tomorrow morn. Writing this all out and thinking it through in response to your points will help me make sure I'm asking the right questions when I do speak to him. In fact, maybe I'll just send him the link to this thread, lol.

Dave Foster · Answer

@Lynn Leigh If you want to take some or all of the sec 121 benefit then you definitely don't want to contribute into an LLC first since the only way to get that is if you're selling a property you own that you have lived in the appropriate amount of time. Right now you qualify. In a month you may need some more residency time to qualify anyway.It is risky to sell a property right after changing entity and 1031 it. There are issues of intent of the entity if it obtains and immediately sells and then 1031sYour personal relationship and tax filing status for each of you plus the quirkiness of CA law in community property tell me you need to get some good legal or accounting counsel regarding your eligibility for 121. But the 1031 option is available for half of that property at least for the current taxpayer of the investment portion.

Lynn Leigh · Answer

Thanks Dave, that's good to know. Is there a reason though that you would not suggest placing the currently owned prop into an LLC prior to the sale? If we lose the ability to take the $500k of gain sans cap gains tax, wouldn't having it in an LLC afford some assist with lessening the tax liability on the gain we are not allowed to 1031, since half the prop has been our primary residence?

Dave Foster · Answer

@Lynn Leigh, boiled down to essentials, the property currently is held by two tenants in common. Those two tenants can sell the property and 1031 with the two tenants also purchasing the new HI property. After the fact, when the 1031 is complete you can contribute the property into an LLC for respective memberships. The contribution of a property into an LLC does not create a taxable event. That is how you can do it.