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Washington DC Attorneys

08/17/08: Tax Scheme: Legal or a Sham?

HOUSING COUNSEL

By Benny L. Kass

Q: When my wife and I married three years ago, I owned my house free and clear. We bought a new house together and wanted to keep my old house for a rental. I knew that I had three years to sell the house to avoid a capital gain, but after that time, we would owe the tax. To avoid the tax, we plan to sell the house (before it is rented) to a third party at the price of a current appraisal. It would have the appearance of an arm's length transaction (which technically it would be). This would be a non-relative, although it would be a very good, trusted friend. I will pay all expenses associated with the sale and sell it with "owner financing" so no bank loan would be involved and no cash would change hands. We would let two months pass during which my wife and I would form an LLC which then would buy the house back from our friend for the same price that he bought it. Also, the friend would make a couple of " mortgage payments", for which he will be reimbursed. We would then have the house in the name of our company with a cost basis at its current value. Is this a loophole in the tax law?

A: I do not like your proposal, and suspect that neither would the IRS.

You apparently will make a decent profit if and when you sell your old house. If you have owned and lived in the house for two out of the five years before it is sold, you can take advantage of the up-to-$500,000 exclusion of gain. Since you have moved out of the house, to preserve your right to this great tax benefit, you must sell within 3 years.

But you and your wife want to rent the house, presumably because you believe it to be a good long-term investment. So you create a situation where you sell the property to a trusted friend, for no money, and then buy it back in a Limited Liability Company.

Your objective is to get the best of both possible worlds: take the exclusion of gain, while at the same time increasing the tax basis of your “new” rental property.

In my opinion, this is nothing but a sham, and your “trusted friend” is only a “straw” figure in your scheme. Although you want to make it look like a sale, it really isn't. There is no way that your buyer friend can be considered a bona fide purchaser.

There are a couple of potential ways to avoid having the pay the capital gains tax, one of which is perfectly legal and the other to my knowledge has not been tested by the courts or the IRS.

A Starker Exchange : Your old home will become rental. When you decide that it is time to sell, give thought to doing a 1031 exchange. If you meet the various legal requirements, you can dispose of the old property (called the “relinquished property”) and obtain a new property (the “replacement property”. No tax liability will be incurred at this time. The tax basis of the relinquished property will be the basis of the replacement property, but until that new property is sold, the IRS will not be owed anything.

And if after a couple of years, you and your wife want to move into the replacement property, there is a legal loophole that you can take. If you live in the replacement property for a full five years, it will be considered your principal residence and you then are able to take the full exclusion of gain, up to $500,000 (or $250,000 if you file a separate income tax return).

If you plan to retire in a few years, this scenario could work to your advantage – especially if the replacement property is somewhere you would like to live in for a number of years.

Sell to a sub-chapter S Corporation : some of us remember that before May of l997, one of the tax benefits available to homeowners was known as the “rollover”. If no more than two years elapsed between the time you sold one principal residence and bought another, you did not have to pay any capital gains tax. The profit that you made on the old house was “rolled over” into the new house. For example, if you made $50,000 profit on the old house, and the new house cost you $250,000, for tax purposes your basis in the new property would only be $200,000 ($250,000-$50,000).

During the period that the rollover was in effect, the IRS issued a private letter ruling. It stated that if a homeowner sold the old house to a sub-chapter S corporation – even if the corporation was wholly owned by the owners of the old house – and if the sale took place within the two year period, the IRS would consider this a sale within the roll-over rules..

It must be pointed out that Private Letter Rulings cannot be used as precedent, since they are only a specific ruling for the person requesting the opinion. However, it does reflect the thinking process of the IRS.

So instead of creating a straw party with a less than valid “sale”, why not consider creating a sub-chapter S corporation, and sell the house to that company. The price would have to be close to the market value, and you would have to pay the appropriate recordation and transfer tax. The corporation would give you a promissory note and sign a deed of trust in your favor, and the corporation would be legally obligated to make monthly (or quarterly) mortgage payments to you.

If there is a mortgage on your property, you will have to get your lender's permission to enter into this type of transaction. Most loan documents contain what is known as a “due on sale” clause, which means that if the property is sold or transferred to a third party, the bank has the right to call the entire loan balance due. There are a number of exceptions – such as transferring property to a family member – but the exceptions would not apply to the sale to your new corporation. In fact, under your proposed scenario, your lender could call your loan due, since your friend does not fall within any of the exceptions either.

Limited Liability companies were not in existence when that IRS private letter ruling was issued. Perhaps transferring your property to an LLC would also work, but the safer course of action – although not guaranteed – would be to sell to a sub-S.

Your legal and financial advisors should be consulted to make sure that you are following all of the corporate rules and regulations.

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