Converting Primary Residence To Income Tax Questions
what a great resource!
I've scanned the archives for my answer but have had no luck finding this topic:
my parents are soon to be moving out of the house I grew up in, and converting it to a rental property which they will most likely sell in 3-5 years. They are buying a new house that they will sell at the same time as the rental.
In order to avoid capital gains (on the ~200K increase in property value) on the sale of the older house (which I believe they would be liable for since it will become an income property) I proposed they sell the house to an LLC formed to administrate the soon to be rental property. (no leases have been signed so the house is currently still residential as near as I can figure)
their primary residence becomes their new house (with a similar value to sales price of old house) which reinvests the gains (from the old house) with no tax burden and, conviently, the capital gains on the LLC are limited to the increase in value for 3-5 years rather than 35 years.
Am I off base here? Is there anything to prevent me from being a partial owner of the LLC? There is no undervaluing of the original house value since we'd value it at market value to keep as much income as possible from being taxed as a capital gain. These transactions would take place at the recently appraised value of the house (from two months ago).
any insight would be appreciated as I'm new to this game and could very easily be missing a big element of something.
-pushing it as hard as I can.
Your parents can convert their primary residence (property A) to a rental, operate the rental property for a couple of years, and then sell the property before three years is up without sacrificing any tax free capital gain on the sale of their primary residence.
Now if your parents also want to sell their new home (property B) at the same time they sell property A, they will still be able to exclude their capital gain on the sale of the property provided: (1) the profit on either property does not exceed $250K, (2) each of your parents is on title for at least one property, and (3) each party satisfies the 2 year rules.
Each of your parents can claim a $250K capital gain exclusion on a separate primary residence sale, effectively excluding up to $500K in profit.
All that needs to happen is to set the timetable so that property A is sold within three years after moving out. Your parents can even convert property B to a rental when they move again to a new home upon upon the sale of property A. After operating property B as a rental for awhile, they can sell it within three years of moving out and still exclude up to $500K in capital gains on their joint tax return.
Although I wasn't aware of the multiple exemption possibility, my main concern is that they will most likely hold onto the property for closer to 5 years than three, effectively nixing that exemption as an option. I guess what I'm looking for is confirmation that sale of residential property to an LLC of which the original deed holder is a shareholder doesn't prevent the use of the 250K exemption.
I will certainly keep in mind the info you provided, which at a minimum, pushes off the urgency for a while.
and thanks.
If your parents sell their home to an unrelated business entity, in an arms-length transaction, they should be entitled to the capital gains exclusion under Section 121.
The problem here is that this deal does not appear to be structured as an arms-length transaction. I don't see any money being exchanged for your parent's primary residence when the property is deeded to the LLC. Instead, you want to defer payment for the property until the LLC sells it up to five years later, with your parents maintaining a controlling interest in the LLC.
Taxjunkie has commented on similar proposals elsewhere in this forum, and he suggests that the IRS might have problems with this deal, perhaps declaring this a sham transaction with no business purpose.
Hmmm...maybe I didn't make myself clear. The LLC would actually buy the property from my parents at fair market value at the time of the transfer. The LLC would be creatd with funds sufficient to secure a commercial loan for the purposes of buying the property and the deed would transfer to the LLC in exchange for the fair market value of cabbage.
Additionally, I had assumed (insert aphorism here) since one would legitimately form an LLC to insulate personal assets from a high liability business operation (renting) that the LLC wouldn't be considered a sham since it provides a real function.
Arm's length is the key I gather. I'll look over taxjunkie's posts to see if I can glean any further insight.