Selling primary house Publication 523 from the IRS

[MaverickAl]

I have a question about Publication 523 (https://www.irs.gov/publications/p523). In August 2021, I converted my primary house, which I purchased in 2014, into a rental property. Now, I've decided to sell it as I don't want to deal with tenants. This sale is eligible for capital gains tax exclusion since I lived in this house for more than 24 months within the past 5 years.

However, my real estate agent has presented me with an offer. Due to my low mortgage rate, the suggestion is to transfer the deed – which currently lists myself and my wife as owners – to an LLC and add him as a partner with 49% share ( he will pay for his portion).  I've discussed this with my bank, and they are willing to permit the deed transfer while retaining the mortgage, under the condition that I control or own a majority of the interest in the LLC (50.1% or more).

My concern is whether, if we proceed with this transaction, my wife or I would still be eligible for the capital gains tax exclusion. I would greatly appreciate any advice you can provide.

[tagteam]

You may get varying opinions on this proposed transaction, but here's mine:

Essentially, you have not actually sold the house to an unrelated third party so Section 121 does not apply. Per the suggestion you posted, what you have done (or would have done) is sell an interest in an LLC to a third party. Thereafter, you, your wife, and the third party would then own shares in the LLC as members with the primary asset being a house.

Note that an interest in an LLC is never considered to be real property but, rather, personal property (personalty versus realty). Basically, you would all be partners in the LLC, since an LLC defaults to partnership status, with the primary asset of the LLC being a house.

If you get a different opinion from anyone (on this board or elsewhere), I would love to hear the rationale for how this proposed transaction would qualify for the Section 121 exclusion.

[Opus 17]

You're going to sell half the house to an entity that will rent it out, but you will keep the other half?  This certainly does not fit the spirit of section 121, and when you sold the other half (whenever that is), you certainly would not qualify for the exclusion on the other half.  

Then there is the fact that the entity you are selling the house to is a related entity.  I admit I don't understand the additional implications of that situation.

Basically you want to have your cake and eat it too.  Sell half the house and get the exclusion, and rent half the house for an income without having to manage it yourself.  My hunch is you would not qualify for the exclusion, and if you do want to claim it, you would want professional tax advice from someone you hired and who will represent you if you are audited, and not just take free advice from strangers on the internet. 

[tagteam]

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@Opus 17 wrote:

you would want professional tax advice from someone you hired........

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Perhaps, look for another real estate agent because, after re-reading the original post, it appears as if the real estate agent (a "professional") is the one who proposed this particular way of structuring this transaction and it further appears as if the real estate agent is the person will be one of the members of the LLC.

With "professionals" like that, taking advice from "strangers on the internet" may be the better option.

[Opus 17]

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@tagteam wrote:

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With "professionals" like that, taking advice from "strangers on the internet" may be the better option.

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I would definitely want professional advice from someone who was not the person who proposed the deal.

For example, you could hire a property manager on a contract, and keep full ownership of the property.  Do you gain something by making the agent a co-owner?  (Possibly, if the agent is a stakeholder, they might do a better job than a contracted manager.)  What are the drawbacks of having a co-owner?

Since you obviously don't need the capital right away, I would also think about how much income you get from investing 100% of the house value in the house as a rental; how much income you get from leaving 51% of the house value invested in the house and investing the other 49% someplace else; and how much income you could get from selling the house and investing 100% of the capital someplace else?

Real estate is a relatively "safe" investment, but its not diversified or liquid.

[tagteam]

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@Opus 17 wrote:
I would definitely want professional advice from someone who was not the person who proposed the deal.

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I agree, but the primary question posed by @MaverickAl was whether this transaction would qualify for the Section 121 exclusion (apparently, having converted the house to rental use in August of 2021, time is running out on the 2-out-of 5-year time period).

Regardless, the answer is in the negative as the sale would be the sale of a ~49% interest in an LLC.

[Mike9241]

i would agree no section 121 exclusion because there would be no gain recognized by you and your spouse by forming a partnership/llc to which you contribute property, and the third party contributes cash. eventually time will expire to for you to use the 121 exclusion.  other issues to you need to consider is who's going to manage the property and deal with the tenants. if it will be the 3rd party, what compensation would they want. a property manager usually is compensated some % of the rents.   you need an outside party, probably a lawyer, to review the proposed transaction for any pitfalls.  considering you want to get out of having to deal with tenants you have substituted a third party, your partner, for tenants.