Which Is Better? Sell owner-carry, or do a 1041 into STR?

Question

I need perspective on which route is better from the vantage point of 1) tax liability and 2) maintaining long-term value in the Estate.

A close family member is aging and wants to get rid of their office buildings, valued at $1 million. They have an offer from the current lessee for $200,000 and an owner-carry loan which would double their current monthly payments received. They'd no longer have to worry about maintaining the old property, which is what they want.

However, as the co-heir to the estate, my concern is they'd be hit hard with taxes on the sale and the longterm value of the estate would essentially evaporate (through taxes and cash received but no asset anymore).

I would love to instead help them sell the offices traditionally (get paid the full sales price up front), and then do a 1041 exchange with that million, purchasing a nice and new home in a nearby resort to be run as an STR/VRBO. I would offer to manage the STR for them (at whatever is the standard commission), and based on my AirDNA data, we would still bring them in that "double the current monthly payments"... plus I would be earning an additional revenue stream, plus there's a solid paid-for piece of property that should retain value and gain equity over time.

Does anyone have insights or perspective on this that could be helpful when I talk with them and help them consider the benefits of a 1041 instead of just selling out of the real estate, and pocketing whatever's left after Uncle Sam takes his piece? I want to be super respectful because it's THEIR property, but I also want to help them think strategically so they don't lose a ton in taxes and the family loses out on an otherwise very valuable portion of what they've worked so hard to build. I realize it's a sensitive subject...Please be kind. :) Thank you!

Chris Seveney · Answer

@Jenni Burke

As someone who buys hundreds of notes, if you can sell it outright do that 100/100 times.

Especially if you can 1031 it, that to me is a no brainer

Henry Clark · Answer

Not financial advice.  No need to answer questions.

Aging person?  How old and mentally stable?  Are they mentally, still legally capable of signing power of attorney's or trust documents?

When they go to a retirement home the state will require them to pay the monthly amount until they get down to zero or $2,000 cash on hand.

Any gifts, funds from sales, etc. in say the prior 5 years will be reviewed and have to be returned to that person's estate.  Even if those funds were used to go to Hawaii or buy a new home or Mercedes.  Whoever received those funds will have to return Cash back.

They will be charged $6,000 to $10,000 per month at the retirement home until all of their resources are used up.

Do they trust you and the other co-Heirs?

Step:

1.  Go to a rest home and ask them to walk you through the finance discussions.  Ask them about transferred assets out of their estate, what qualifies.  Action- talk with a rest home in your state.

2.  Leasing out the buildings.  How good are "you" at doing commercial leases?  Do you know about liens, insurance additional insured, property tax nonpayment, penalties, capex, etc?  What happens if the tenant or buyer runs the property down, what is your plan?  Is it built into the lease, measures and penalties?  Balloon payment at 5 years, escalation clauses,.  Action- talk with an attorney or commercial leasing agent to draw up the lease.

3.  Co-heir- there will be nothing left of the $1mm estate at $6,000 to $10,000 per month based on your plans above.  Action- come up with a different plan.  Talk with a Tax planner and a Trust Attorney.  Ask them about gifting.  Installment sales, under the Capital Gain Minimum.  Etc.

4.  "Their" property. If this is a man and woman married couple.  The man will go into the rest home first.  Their wealth will get eaten up by his 5 year stay.  The woman will be left penniless and live for another 20 years.  Action- Come up with a different plan.

Action-  Use the magnifying glass above and look up my name and post.  "What happens if you die?"  Make sure you have those items covered.

Jenni Burke · Answer

Thank you, Dave Foster. That's what I thought. Appreciate you taking the time to reply!

Dave Foster · Answer

@Jenni Burke, A sale and 1031 exchange would indefinitely defer the tax.  And this would indeed go through death when the tax is eliminated by the step up in basis for the heirs.

A sale and owner carry will recognize all the tax.  Some of it may be delayed.  But a lot will not.

So from a pure tax perspective for both current and future owners a sale and 1031 is the most efficient way to handle that.

Henry Clark · Answer

Talk with an estate planner.

If there are two aging adults the commercial building won’t make it to death stepped up basis before those funds are needed for a retirement home.

They should have a paid off house.  Talk with their tax accountant about selling their house. If primary residence and they have lived there 2 out of 5 years they jointly can sell and avoid paying taxes on $500,000 capital gains.  Don’t need to wait for step up.   If they want to stay there for a few years have them sell it to you.  That way you and them control rent rate and loan payments.  Also you take over house maintenance using a service.

Their loan to you is still an asset.  You need to get rid of it before 5 years before they go into a rest home. Understand gift tax limits and exemptions.Check out neighborhood group homes, although I think a  nice retirement home is better due to more activities and trips.  See if they have any plan policies.

If you read the post I noted above by now you have discussed with them making their bank accounts TOD to you.  Go thru the list while they are still active.

David M. · Answer

@Jenni Burke

Depending on the cost basis of the property and how the loan is structured, the sale may not be that bad of a tax hit.  As a owner-carry back loan, they'd only get taxed on their profit, i.e. the principal they receive above the cost basis.  For example, if the cost basis is $300k, they would need to receive anotehr $100k before they would get hit with capital gains tax is my understanding.  Of course, consult a qualified professional.

Of course, the interest payments on the loan would be taxed as ordinary income.  For example, one could structure the loan to be interest onlyi for the first 5 years, than start an amortization...  whatever...

As mentioned, upon your relative's death, the "asset" would get a step up in basis and the Note would transfer to the heirs.

I don't necessarily agree with the concept of the "...longterm value of the estate would essentially evaporate.." since you've just converted the value into a Note.  The wealth has just been transferred into a different asset/instrument.  You just may not like it.  don't forget, you can still sell the Note, or at least your portion of it when you inherit...

All that being said, sure a 1031 exchange would defer the tax liability and upon their death would basically eliminate it.  Just some "little things" to think about for optimization:  do you lose "too much" in the sale and buy transaction for the exchange?  What is the risk of your STR property not holding its value over time (unlike the Note) --- you can still lose money in holding a real property?  What is the risk / impact if the STR market would to turn and you were not able to make the income for your aging relative?

Like you said, you are trying to be super respectful of THEIR property.  However, at their higher age, usually wealth protection/sustainment and income is MUCH more crucial then wealth generation.  I think you realize, given the way you've written the post, that you are trying to optimize the investing strategy for yourself as an heir.  What is the balance point between doing that and still be "truthful," for lack of a better term, for your aging relatives?  Rhetorical --- not something to be decided on a public forum.

I hope that helps.  Good luck.

Dave Foster · Answer

@Jenni Burke, You're welcome!  I sent a colleague request to you if you'd like to process further.

Which Is Better? Sell owner-carry, or do a 1041 into STR?

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