Discussion:Principal place of residence exclusion

Back in 2001 when the election was available to report gain on a stock still held in the portfolio, some people came up with combining that with the 121 exclusion to get a stepped up basis on the sham sale. Revenue Ruling 2001-57 put the first kibosh to this, then Congress amended Section 1223 to bar it. I recall asking about it at a seminar. The person doing the presentation said people had big mouths in publicizing this wonderful tactic.

That 2001 situation saw some accountants sending out mailings to drum up business in places like Westchester County NY where a 500K runup in value was not uncommon. This was a step transaction in kind and which gave me a subject for a nice piece, Seven Hawks Circling. http://www.writing.com/main/view_item/item_id/260324

Not always. There are a myriad of cases out there where the IRS has *successfully* attacked transactions as being tax motivated and without a significant business purpose. The business purposes you've listed here would never pass muster when compared to the significant tax benefit gained from the transaction.

There is no extra step that is taken (step transaction) The property will never be sold? When it is sold, there's your step transaction.

the related party rules only apply to the recognition of losses I don't think so... you should check case law on this...

Remember, in order to avoid preparer penalties, there's now a "more likely than not" standard for return positions. There's no way this would meet that standard, so you would be required to disclose the position...

I'm not letting you guys disuade me I was just hoping that someone saw something that I didn't already see. As mentioned, I'm not worried about sham based arguements, I just don't want to be giving my clients bad advice. I guess what I'm really looking for is confirmation (which I'm clearly not getting). Especially in Florida, I think there are alot of people in this same boat (have substantial gain in there homes - but think the market is to bad to sell - and do not want to lose the 121 exemption). I appreciate all the replies.

I'm sure it's occurred to you that once the LLC establishes basis at FMV, and the real estate market drops further, the LLC can then sell and the loss is now a business loss which flows through to the partners!

WOW!

My hypo is for the entire interest thus bringing into play 121(d)(8)(B).

Beatle Fred may want to go back to school to assist him/her with spelling or get a new darn keyboard.

Wjlaw - since you didn't fill out your profile, we can only assume from your handle, your are: a) an attorney duly licensed by your state to practice law; b) a law school graduate sitting for the bar; c) a paralegal at a law firm; or d) none of the above.

You come here seeking advice and many people here are giving you some practical advice and you wish to ignore it. Fine, do so. But you don't want to give your clients bad advice, which you may clearly be doing. It's up to you. We all want to minimize our client's tax burden, but at the same time, if there is a pattern of advice which is leading you down a straight path that your client's are screwed, then don't take the crooked path.

This frosts me because I had a new client in here today that made a killing on selling a partnership interest and has to pay tax on it. Everything I did points to this guy owing north of $90K and he's mad because he made money and has to pay tax on it. I point blank told him, "you made money, you have to pay the tax." And there isn't a darn thing he can do about it.

And that's what happens in this business. People do a transaction a certain way and on the back end they are looking for a way out of owing tax. Well, sometimes that's just too darn bad. They should have thought about that in the first place.

Tom

"Transferring the house to an LLC won't work. If you sell that property to the LLC, you won’t be able to use your personal residence exclusion. In fact, you can’t sell your property to your LLC, since your LLC is you.

That’s called a related party. If you own 100% of an entity, it’s still you!

Second, even if you did transfer it to the LLC, it would go in there at your present basis. No step-up."

But as Taocpa states; hey it is up to you. But believe me these people will be the first to complain, or worse, if the IRS knocks the transactions out.

Transferring the house to an LLC won't work. WHY? If you sell that property to the LLC, you won’t be able to use your personal residence exclusion. WHY?

In fact, you can’t sell your property to your LLC, since your LLC is you. REALLY? (maybe your thinking of a single member LLC which is treated as a disregarded entity)

That’s called a related party. If you own 100% of an entity, it’s still you! The fact that it is a related party has nothing to do with an entity being disregarded for tax purposes. Second, even if you did transfer it to the LLC, it would go in there at your present basis. No step-up." WHY? If it is not a disregarded entity, and the code only provides for nonrecognition of losses when you sell to a related entity, any gain recognized would surely be offset by a basis adjustment. Would we all not want to have the ability to council our clients to save money on taxes? I’m not sure where the hostility is coming from. If I’m right, would this not be a good thing to be able to share with our clients in this situation? They are not trying to get out of anything, the code clearly allows for exclusion of gain for the PPR which we are trying to use.

Do you really believe this meets the "more likely than not" standard to allow you to sign the return without attaching a disclosure?

When the exclusion was passed in 1997, a client came in a few months later to ask the managing partner about this (may have read it somewhere). The MP passed on the research to the library wonk (me). If you have access to the BNA portfolios, they stated that this WAS an option, but they were using an S Corp. You are right that 267 doesnt apply for the reason you stated. Look to a Supreme Court case named Bradshaw for sale of property to a wholly owned corp (must be bone fide, legit FMV, and interest rate if applicable, blah). Two issues outside of tax to consider (1) if the property has a mortgage and is sold to the S Corp, would that trigger the due on sale clause? (2) would the transfer cause problems with homeowners' insurance? Also, Kleinrock has a "tax strategy" paper on this. Let me know if you want a copy of it.

Again, the MMLLC is NOT a disregarded entity, it is treated as a partnership. And my suggestion was to use an S Corp which is also NOT a disregarded entity. This is not something that WJ just came up with. I researched it in 1998 and RIA Checkpoint, Kleinrock and BNA state that it is supportable under current law. If Congress wants to close this "loophole", they can do it and that will change the outcome, like they did in Gitlitz and many other situations. The arms-length bona fide sale of property to a wholly owned corporation is settled law and while the IRS might not like it, it's up to Congress to change the rules. To assume that they would change it and therefore not take advantage of the Code as it presently stands is a decision each practitioner has to make.

We are not doubting your research, however, in the scenario Wjlaw presented he used an LLC. It might work with an S Corp. I can't answer that question to be honest, at least not now.

My problem with this: it's another example of, to use a worn cliche, "closing the barn door when the horse is already out of the barn." The way I read Wjlaw's scenario: the client turned the property into a rental after using it as a PPR and now seeks to take advantage of Section 121 after significant property appreciation. While I wholeheartedly agree we should seek to minimize a client's tax burden, this MAY be a case where there are no options as people have pointed out using the LLC. Your S Corp scenario could as well be an option. We aren't doing our job if we don't seek options for our clients. Of course, those options shouldn't include outright fraud (which I am not saying is the case here).

Wjlaw wanted a "group hug" for his idea. Well, he didn't get what he wanted. Sometimes that's the way it goes. Many are professionals who have been here on this board for a while and you learn who knows what they are doing by reputation and/or their profile (which neither you or Wjlaw bothered to fill out). Kevinh5, D&T and Taxref have solid reputations as contributors to this board.

If I post a question here, I expect these professionals to guide me down the right path. Sometimes it's not the path I prefer, but such is life.

The next sound you here is my soapbox being put away.

Tom

I misused the term 'disregarded entity' since you are correct that because it is husband and wife, a partnership would be the default classification, but I am curious what happens if the taxpayer is single, or head of household....Schedule E disregarded entity? By such reasoning this strategy would only serve the married couple and the more I think about this idea, the more this basic difference between a married couple and a single person brings us back to one being disregarded, while the other is considered a partnership by default.....different treatment of the same situation, or is the argument that the LLC is enough separation to create a different entity even though the rent is reported on Sch E.

Another interesting question is realized versus recognized gain: does the partnership have a new basis to depreciate? See Discussion: Sale of Duplex - 1/2 Personal and 1/2 Rental for some views on this, though it is a bit off topic. What happens if the couple moves back into the property as a residence again?

Or is the OP simply going to tell his client he has this great idea that's going to save them all kinds of money?

In our fact pattern the taxpayer "DOES NOT WANT TO SELL" therefore he has made a decision to convert the property to rental. As you have stated above there are potential pitfalls that arise from the rental of your residence. One is if you wait more the 3 years after the conversion you LOSE your exclusion capabilities. Tough DODO. The taxpayer is making NO effort to sell the property.

Now I have seen the use of an S corp to sell the old home to is/was/maybe a viable alternative to losing your tax benefits due to time running out. It was used under the old rules where you had to sell your home timely to defer the gain if the proceeds bot a new home. In that case the taxpayers bot the new home first and had trouble selling the old home. BUT there was always the intent to sell the old home. In our case we have no intent to sell. This taxpayer is just trying to figure out how to have his cake and eat it to. Now if he does go through with the sale to a related party deprecaition recapture at 25% will have to be recognized.

I vote the IRS would construe this to be cake and eating it to. OINK bye

Since Douglas's post, most everyone has backed off the "substance over form" points that were offered (over an over) and has concentrated on the difference between an S Corp and a MMLLC. Can anyone think of any reasons why there would be a difference in tax treatment? The "due on sales" clause is definitely something to consider (that I had not thought of). I'm not sure how whether or not the property is turned into "income producing property" is relevant. What would it make a difference (besides the fact that my client would have to recognized the depreciation taken as ordinary income) if the property was their vacation home? Again I appreciate the replies.

John Huddleston Seattle Bellevue Tax Accountant

Why does this not surprise me?

I getting a little afraid to post here. I hope you stick around WJ.

John Huddleston Seattle Bellevue Tax Accountant

For those who constructively added to this post; I appreciate it, will do some more research, and let everyone know if I reach any conclusions.

John Huddleston Seattle Bellevue Tax Accountant

And once again, how would this work for the single man or woman? The availability of such tactic should be available for both, but a SMLLC, while an LLC, is taxed as a disregarded entity, or the election must be made to be a corporation. Of course, maybe I am misreading your intent for it is Doug who notes that a MMLLC is not a disregarded entity. But if such an idea is not available because the taxpayer is not married, yet has the same access to Section 121, it would seem this would be another strike against the idea.

I know this is not an arms length deal. But if FMV is documented . . .

I'm not sure but I'd like to know the answer.

John Huddleston Seattle Bellevue Tax Accountant

I recently did a substantial research project on the real estate developer rules (requiring ordinary income treatment) and there is plenty of support for selling property to an LLC or S-corp. at FMV in order to limit liability even when ownership is exactly the same.

WJ - sorry about the bogus code section earlier. If I had a chance to advise the client before they turned the home into a rental, I would probably have advised them to sell the home to their LLC and exclude the gain. I don't see why that should change two years down the road when the exclusion is still available. The tax objective is the same in both situations.

If a single person owned property and sold it to anyone (or any entity) besides their own SMLLC (which is not taxed as a corp in a bona fide purchase for adequate consideration in money or money's worth....; it is my suggestion that it would be respected. I'm not sure where the issues lies regarding single vs. married.

How is the LLC going to pay the taxpayers? Did they pump it full of cash? Are they going to get a note? Mid-Con Petroleum Inc. and its shareholders got in trouble recently for using sham notes. Feel free to make use of 8275/8275-R and Sec 7623.

I find it odd that I cannot rent from myself [Schedule C paying rent to a SMLLC) Discussion: Single member llc paying rent to member even though I might have good business reasons, but through use of this strategy, I can sell to myself.

I think TC puts it in perspective: if business reasons for placing the property in an LLC are strong enough, simple transfer or contribution can suffice.

Taxpayer and spouse buy house for 200K in December 2003 and uses it as principal place of residences until January 2006. On January 2006 the FMV of property is 500K. From February 2006 to present, the house has been a rental property. The current FMV as of December 2007 is 450K. Taxpayer and spouse sell the property to an LLC (taxed as partnership) for FMV (450K) in December. The LLC is owned equally by Taxpayer and spouse. What are the tax consequences? Are Taxpayer and spouse able to recognize the gain from the sale of the Property? Are they able to exclude that Gain (under the 2 of the last 5 years principal place of residence exclusion)? If so, is the LLC's new tax basis 450K? Does the fact that Taxpayer and spouse finance the transaction?

Here is the answer:

Yes, if the taxpayer meet the 2 out of five year own and occupy requirements, they are able to exclsude the gain on the sale of their principle residence. Please see the following information, especially the last sentence. .903.2 Gain (or loss) on the sale of a principal residence is the selling price less expenses of the sale and the taxpayer's adjusted basis in the residence. Adjusted basis is original cost or, if the taxpayer postponed gain under former IRC Sec. 1034 when the residence was acquired, cost adjusted for deferred gain. The cost of improvements (but not repairs or fixing-up expenses) made to the residence increases the taxpayer's basis, and any depreciation claimed on the property decreases basis. (See Pub. 523 for information on what constitutes an improvement versus repairs.) A sale to a relatedparty such as a closely held corporation or family limited partnership will presumably still qualify for the gain exclusion since such sales qualified under the old gain rollover rules (Ltr. Rul. 9625035).

The LLC's new basis is sales price, $459,000. It does not matter how it is financed.

John Huddleston Seattle Bellevue Tax Accountant

Thus in the letter ruling, the sale to a related party meant only that the taxpayer's replacement residence had to exceed the selling price of the old residence, and its basis was adjusted to reflect the deferred profit, and all of this had to occur within a timeline of two years. A sale to related party would happen when the purchase of the new came before the old, and with the two year period expiring a sale had to be made to close the ledger. Yes, the old residence, now held by a related party, had a step-up in basis, but basis on the new was adjusted. The old residence had no relevance any more except as a second residence, to be taxed upon sale. Two piece of real estate had to be involved.

I am still of the opinion that the situation addressed by Rev. Ruling 2001-57 and the subsequent congressional action is closer to the idea in the original post.

Real Estate Professional's Tax Guide Database updated November 2007

Alvin L. Arnold and Myron Kove

Part 4. Tax-Deferred Exchanges of Real Estate Chapter 28. Tax-Free Sale of Personal Residences

References

§ 28:5. Eligibility requirements--Definition of principal residence--Sale of principal residence To qualify for the exclusion of gain, a sale of a principal residence must occur. This includes not only a traditional sale but also an exchange of properties; in such case, the consideration received by each party, instead of cash, will be the fair market value of the property received minus any mortgage or other debt assumed by the party. A sale or exchange with a related party presumably also will qualify under Section 121 so long as fair market values are used to determine the realized gains. A bargain sale to a charity in which the seller realizes a gain has been held to qualify for the exclusion under former Section 121.

© 2007 Thomson/West

REPROFTAX § 28:5

END OF DOCUMENT

John Huddleston Seattle Bellevue Tax Accountant