Planning on consolidating title on an investment property and involving a Reverse 1031 in the process?
For those of you who understand the value of California’s Proposition 13 you may conclude in your tax planning that your portion of a long-held multi-owner investment property is protected from reassessment when you need to consolidate to yourself a portion of the property.
Just a refesher, 1031s only deal with investment properties or properties intended to be used for investment purposes. In general, 1031s are a means by which capital gains from an investment property sale may be deferred as long as they are reinvested into another investment property.
If you are planning to execute a Reverse 1031, then please consider the following info and be aware not only the capital gain benefits but of the potential property tax consequences. The State of California does not look at your escrow transaction as only one property transfer, it will see it as two re-assessable transfers even though it is only in a single escrow.
Let me try to explain this mess that took me awhile to figure out.
In a Reverse 1031, an LLC title holder, which is under the responsibility of a 3rd party neither the buyer nor seller, must be created to hold the title from the consolidation sale until such time the buyer can release the title with funds from another investment property sale.
Here’s the basic difference: A Forward 1031 LLC holds funds. Reverse 1031 LLC holds title (waiting for funds to release it). Property tax doesn’t figure into moving funds between title holders, but it does involve itself with transferring title between separate title holders.
As just a regular tax paying citizen (I am not a real estate professional and I am not a legal professional), the best I can tell, having argued extensively with my County and inquiring to the State Board of Equalization, Reverse 1031s fall within a loophole that gives the State the opportunity to assess your property twice for the percentage of title transferred.
Again, although it may be your intention to consolidate a percentage of an investment property from a co-owner, the necessary deposit of the title into an LLC created by the Reverse 1031 will create two title transfers and interpreted that way by the county (although it is only one escrow).
If within a Reverse 1031 you are transferring a very small portion of the property’s title, the property tax consequences may be insignificant.
However, if you are changing hands of equal shares of the property, presuming the co-owners hold significant percentages, you will be reassessed for an amount that is two times greater than you would normally expect. In simple math, if the seller held 25%, in a Reverse 1031 the county will reassess the property for an equivalent of 50% of the title changing hands based on the market value.
Important note: An assessor in California will reassess the percentage of un-excluded* (see note at bottom) title transferred every time it transfers. In certain transfers, the reassessment may be subject to a legal exclusion, such as parent to child (but not sibling to sibling).
Your situation may be this: Due to pressure from the selling party to expedite the deal, you may be put into a position where you may need to adopt a Reverse 1031 to preserve your capital gain deferring strategy.
Unlike a Forward 1031 where the funds are held from a previously sold investment property and would be used to purchase, in this case, the portion of property to be consolidated, a Reverse 1031 requires non-1031 cash up front, to purchase the property. The seller benefits being able to put the deal behind him while the buyer holds the bag until he can release the consolidation title from the LLC holder using funds from a not-yet-sold investment property.
If a Forward 1031 can be used, the funds held in the LLC holder may be used to purchase the seller’s portion directly and the consolidated title does not have to transfer in and out of an LLC holder. In a Forward 1031, funds, not a title, from a relinquishing property sale are held in LLC.
In other words, in the Forward 1031 situation the consolidated title is not reassessed two times**, because the title is only transferred once and that is directly to you, not through the LLC.
Legally, it seems the crux of the problem lies in, despite the fact that the whole intention of the escrow is for the seller to transfer title to the seller, in spirit, a single transaction, the Reverse 1031 process introduces a bug that is exploited by state and county government, thereby overriding the spirit of protection offered by Proposition 13.
In other words, in using a Reverse 1031 in California, unless there is a successful legal challenge to this practice, expect to have the same title reassessed twice in one act of consolidating. Furthermore, were you to completely consolidate the property to your name, using a Reverse 1031 anywhere in the process, you could end up in a situation where the previous property tax basis that you have enjoyed no longer exists in any percentage.
A 1031 officer can provide a petition that describes the intent of the Reverse 1031 LLC as only a temporary holder, but good luck in trying to convince the county that they ought not to reassess a title transfer that is not specifically excluded in their checklists (i.e. parent to child).
It may be worth your time to explore some alternatives with an experienced and knowledgable 1031 officer well-versed in Forward and Reverse 1031 options.
As a final thought, if a Reverse 1031 becomes applicable in your real estate situation, once substantial long term property tax consequences and the personal sacrifice via losses due to the increased liabilities are understood, they ought to be considered by all parties involved.
Disclaimer: The information in this article is based on the author’s personal opinion and is not intended to be legal advice. The author is not a tax professional, real estate professional or other law professional and the information in this article shall not be construed in any form to be a substitute for certified licensed professional advice.
*Note: You will need to determine which transactions are legally excluded from title transfer reassessment in your county and/or state.
**Note: Ensure in your Forward 1031 process that the title is not transferred into an LLC. Discuss and confirm this detail to legal certainty with a certified 1031 officer.