Creative ideas for this property acquisition?

Question

Hello BP community, I have a question for you, I’m assuming someone has tried something like this but I can’t seem to find much information out there, so maybe not. Here is my situation:

We have a motivated seller, he has a 4 unit apartment building (technically fee-simple townhouses, they are all separate parcels, but not really important in this discussion) he would like to sell.  He has owned them for a long time so they are fully depreciated, but he has refinanced them multiple times – so he still has a pretty high mortgage.  My understanding is he will have to pay capital gains tax on almost the entire value of the sale price (minus land value and any capital improvements) since they are fully depreciated.

The problem we are trying to solve for: Is there any way to transfer the property to us where he can avoid paying the taxes?

Our thought for a creative solution…we form an LLC together, he transfers the property into the LLC, we refinance the property to pay off the old mortgage and give a “buyout” to the seller for his position in the LLC at a later date.  At the end of the day we have full ownership of the property and equity in our LLC for no money down and seller is happy because they got more money than they would have selling traditionally.  Is this legal? Is there other ways to do this?

Here are some numbers we are looking at:

If the seller sells on the open market, this would be his approximate situation:

Sale price = $200,000

Realtor commissions (6%) = $12,000

Payoff mortgage = $125,000

Money back before taxes = $63,000

Tax bill (assume taxable gain of $150,000, capital gains of 28%, state of 5%) = $38,000

Net money to seller = $25,000

If we transfer the property into the LLC, here is how we are thinking about it:

Asset contribution value to LLC = $175,000

Refinance (75% of $200,000) = $150,000

Payoff old mortgage = $125,000

Money to seller = $25,000

Remaining seller equity in the LLC (to be paid out in an agreed upon time frame, 5yrs?) = $25,000

Has anyone tried anything like this? Is there better ways to structure this deal or make it a win-win? Our goal is to acquire the property with little or no money down, sellers goal is to get out and have the most money in his pocket with the least amount for the government.  And of course we want to make sure we are doing everything legally.

Any feedback is appreciated.

Bill Gulley · Answer

Buy it Sub-2, he carries the difference of equity as a second mortgage, you get a special warranty deed.

His taxes will be due on the principal amount received, not the entire sale price but from his basis, so seller financing defers his tax liability and he will be paying interest income on his equity amount he carries back.

You also need to be in a position to refinance or sell in the event of any due on sale issue, if it's commercial, the lender may allow you on the note with him, the more on thee hook the merrier.

If the properties are in an LLC, you can buy into the LLC as a member, your arrangement is through the Operating Agreement to buy him out and his taxes will be the same as seller financing as an installment purchase.

There are other ways, doing a long term option and lease, but you should really take title.

Good luck :)

Bill Exeter · Answer

I'm just weighing in here quickly.  Installment sale treatment under Section 453 allows capital gains to be deferred over the term of the note, but not depreciation recapture.  You should carefully evaluate the amount of depreciation that he has taken over the years to determine how much of this would be required to be recognized and realized in the year of sale. Depreciation recapture is always a surprise to taxpayers.

Bill Gulley · Answer

Well, thank you Brian, for your post of the day, it's not rocket science, LOL

Bill is absolutely correct, his basis will include the depreciation taken over the years, that amount borrowed is irrelevant as his principal is repaid, that will be income to him.

I'd suggest you take your deal to his tax advisor and use his input to form the best solution.

Investors make a big mistake trying to be all things to all people, it's always better to work  with other advisors than trying to advise on taxes and legal matters that investors are clearly not qualified to go into. Unless you are an accountant and tax advisor, don't go there!!!!

My advice in dealing with attorneys, is after they try representing their client with BS stuff, ask them if they are willing to make the seller a better deal, on the spot, that usually shuts them up to deal with the offer on the table! If they can't or won't back up their opinion with cash on the deal, it's usually hot air. :)

David Hayes · Answer

Thanks for the great feedback @Bill G. , very helpful.  Our first thought was actually to purchase Subject-To, but I didn’t think about him carrying his equity portion as a second mortgage.

A couple of clarification questions just to make sure I understand.

“His taxes will be due on the principal amount received, not the entire sale price but from his basis,” – So in this case, I looked up the land value, it’s ~ $75k.  Assuming the Sub-2 purchase price is $200k and the remaining $125k is fully depreciated than his principal that he would be required to pay taxes on is $125,000, correct?  But if I understand  what you’re saying correctly, by making it essentially a seller financed deal, he is not actually receiving the $125,000 all at once, he is receiving it over time, thus not significantly impacting his tax situation in one year. Ultimately he still pays taxes, but by deferring it’s in a lower bracket, thus less overall taxes in the grand scheme of things. Is that right?

You also mention “he will be paying interest income on his equity amount he carries back” – Do you mean he will also be paying taxes on the interest received from the seller financing of the second mortgage he is providing? I’m also assuming we will get to deduct the interest expense of both the current mortgage and the second mortgage on our side, even though the primary mortgage is still in the sellers name.  Is that correct?

I’m clear on the need to be able to refinance or sell in terms of any due on sale issue, that shouldn’t be a problem.  And your last point – unfortunately it’s not in an LLC, but I will keep that in mind for future subject-to purchases.

Thanks again for your help!

David

Brian Gibbons · Answer

This is my post of the day - meaning best post on BP, in my humble opinion.

I wish everybody would read this,  print it out, and learn how to do all of it.

And I miss @Bill Gulley on your posts Bill.

Happy Thanksgiving to you and your family.

Creative ideas for this property acquisition?

Most Popular Reply