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Property sale/Tax/Inheritance idea. Possible?
Old 07-11-2020, 04:59 PM   #1
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Property sale/Tax/Inheritance idea. Possible?

So here is a puzzle for the tax and legal minds - I'll surely be running this past our tax person, but only after she's done quivering after the 15th. I imagine there is a way to write up what I propose, but if I'm wrong or proposing something grossly illegal I'd love to hear about it!

Gal and I (70) own our rental properties jointly with right of survivorship. A married 45YO; Bob, with 10YO son has helped with the rentals for years. We would like to benefit him now and in the future and decrease our rental involvement. Looking for all of us to benefit.

An agent with a 1031 client offered $765k for an 8-unit we own outright. 25% down, 4% interest, 10 year contract.

Instead of doing that I'm thinking that we sell Bob the 8-unit for $700k, no money down, 5% interest only loan, and have the contract state that any re-sale requires us to be paid off but also that at the time of the final seller's death, let's say Gal, the contract is satisfied or rendered null or transfers on death to Bob, so that at the time Gal and I both get dead Bob owns the 8-unit free and clear. With us being 70 Bob could have a contract that runs 10-20 years.

Our taxes at time of sale to Bob would be on depreciation recapture and any principal we receive. Unless the property was resold our principal received would be zero through the rest of our lives. We would owe taxes on interest we receive; $35k/year.

In 2019 the property had an income of $51k after expenses but before depreciation deduction. If Bob bought the property from us for $700k his interest expense each year would be $35k, leaving him $16k positive cash flow. If his depreciable basis was $600k (cost minus value of land)his annual depreciation on the buildings would be about $21.8K, leaving him with a taxable loss of $5.8k to write off against his other rentals.

If Bob chose to sell after our deaths would his sale taxes be based on depreciation recapture and capital gains over the $700k purchase price - even though he hadn't paid a dollar toward the principal? Bob would already own the property, so how would a TOD or satisfaction/nullification of the mortgage be treated. If he were inheriting a property he would get a stepped up basis, right? How would mortgage satisfaction/nullification be treated? I'm thinking no step up in basis.

In my mind this sort of means that we shift payment of capital gains taxes to Bob (which seems fair since he would have paid zero principal for a valuable property) and takes the tax paying onus from us, since we didn't get a dime in principal from it. We convert our rental property into an interest paying vehicle that becomes valueless to our estate (except for Bob) at our deaths - sort of what I imagine an annuity to be.

Please come up with problems you see, but understand that we are not worried about making $16k/annum less on the property than we currently do. We aren't concerned about Bob selling and possibly scoring a big profit 2 or 5 years from now. We do not want to manage property managers. The idea is to divest now but maintain some guaranteed income. Is what I propose a doable and legal plan?

Thanks all

Edit: of course we could be like Jeanne Louise Calment and live to 122 1/2 - watch out Bob!

"In 1965, aged 90 and with no heirs left, Calment signed a life estate contract on her apartment with notary public André-François Raffray, selling the property in exchange for a right of occupancy and a monthly revenue of 2,500 francs (€380) until her death. Raffray died in 1995, by which time Calment had received more than double the apartment's value from him, and his family had to continue making payments. Calment commented on the situation by saying, "in life, one sometimes makes bad deals."
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Old 07-11-2020, 06:26 PM   #2
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I’d suggest running this by a real estate at toy as well as your tax guy. To me, it sounds doable.
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Old 07-11-2020, 08:29 PM   #3
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One thing to watch out for is if you forgive mortgage debt, then Bob would owe income tax on that amount, which would be substantial on $700K and might be impossible for him to pay without selling the property. I don't know if there's any difference if the forgiveness is part of a will, but I'm guessing not. Maybe there's some technicality where you can leave him $700K in cash and he can use that to immediately pay off the debt to the estate. You need to talk to an estate attorney to see if there's an issue with forgiving debt via a will and if there's a way around it.

If Bob's name were on the deed, and you held a mortgage lien against the property, he would not get a step up in basis when you die. His basis would be figured on the sales price, improvements, depreciation recapture, etc.

I wonder if there's another vehicle for this such as an irrevocable trust with you and Bob as beneficiaries, where your life benefit is $35K/yr and his is to inherit the remainder when you die. Or maybe an LLC would work, where you each own a percentage and he inherits your part. The problem with having a separate entity hold the property is that then it has to pay taxes.

Whatever you do, it's got to be something that protects Bob so that he can't lose the property because you have to go on Medicaid and there's a 5-year lookback, or you lose a lawsuit, or whatever.

I think your next step is a lawyer.
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Old 07-12-2020, 12:52 AM   #4
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Originally Posted by cathy63 View Post
One thing to watch out for is if you forgive mortgage debt, then Bob would owe income tax on that amount, which would be substantial on $700K and might be impossible for him to pay without selling the property. I don't know if there's any difference if the forgiveness is part of a will, but I'm guessing not. Maybe there's some technicality where you can leave him $700K in cash and he can use that to immediately pay off the debt to the estate. You need to talk to an estate attorney to see if there's an issue with forgiving debt via a will and if there's a way around it.

If Bob's name were on the deed, and you held a mortgage lien against the property, he would not get a step up in basis when you die. His basis would be figured on the sales price, improvements, depreciation recapture, etc.

I wonder if there's another vehicle for this such as an irrevocable trust with you and Bob as beneficiaries, where your life benefit is $35K/yr and his is to inherit the remainder when you die. Or maybe an LLC would work, where you each own a percentage and he inherits your part. The problem with having a separate entity hold the property is that then it has to pay taxes.

Whatever you do, it's got to be something that protects Bob so that he can't lose the property because you have to go on Medicaid and there's a 5-year lookback, or you lose a lawsuit, or whatever.

I think your next step is a lawyer.
Hmm. I was hoping that the mortgage with a TOD could be like stocks with a TOD that just transfer to the recipient. But maybe that would be like saying he had to pay himself off. Move money from his right pocket to his left every month after we croak?

Willing Bob $700k to pay off the property doesn't protect him against us changing our minds pre-death - not that we plan to, but were I him I'd have that concern. The irrevocable trust sounds like a real possibility, though i want him to have maximum freedom to do with the property as he deems fit including the ability to sell.

I appreciate the fresh ideas and warnings - way too many unknown unknowns in this and these comments give me things to ask a lawyer or suggest as possibilities.
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Old 07-12-2020, 08:07 AM   #5
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One thing to watch out for is if you forgive mortgage debt, then Bob would owe income tax on that amount, which would be substantial on $700K and might be impossible for him to pay without selling the property. ...
The OP will have an asset... the right to receive certain payments under the installment contract. I wonder if the OP could make Bob the beneficiary of that asset in their will.... at which point he doesn't have to pay himself and even if he did I'm not sure if there are any tax implications.
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Old 07-12-2020, 08:14 AM   #6
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I wonder if you could transfer the property to a LLC with say 100 shares, have Bob manage the property for you and then just transfer x shares of the LLC to him each year in exchange for him managing the property and you would then both receive cash distributions for your proportionate interests in the LLC.

Then in your wills, each spouse is primary beneficiary of any remaining shares, and Bob is contingent beneficiary, so Bob gets your remaining shares when the second of you dies or if you die simultaneously.

In that way, the property never gets "sold" since it is owned by the LLC but Bob ends up with control of the property. The downside is that you have just effectively transferred your exit tax dilemma to Bob in the event that the LLC sells the property.

Not sure if this would work, just thinking out loud.
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Old 07-12-2020, 09:44 AM   #7
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Originally Posted by pb4uski View Post
I wonder if you could transfer the property to a LLC with say 100 shares, have Bob manage the property for you and then just transfer x shares of the LLC to him each year in exchange for him managing the property and you would then both receive cash distributions for your proportionate interests in the LLC.

Then in your wills, each spouse is primary beneficiary of any remaining shares, and Bob is contingent beneficiary, so Bob gets your remaining shares when the second of you dies or if you die simultaneously.

In that way, the property never gets "sold" since it is owned by the LLC but Bob ends up with control of the property. The downside is that you have just effectively transferred your exit tax dilemma to Bob in the event that the LLC sells the property.

Not sure if this would work, just thinking out loud.
Having proportional shares and disbursements from an LLC could work, but having the proportion change each year feels like a problem - Bob would start with a small portion of the LLC and thus get a small part of the cash distributions for his management. If 5% of the LLC went to him each year (and for purpose of easier math) profit in the LLC was $50k/year he would start by getting $2500 for his first year of management, getting to $20k after his eighth year. That would make Gal and I majority holders of the LLC for the first 10 years, so we could block sale of the property if we chose up till that time. It would maximize income for us during the times we are most likely to be alive, which is good for us, not so good for Bob. Doesn't take us completely out of management or liability. I assume the LLC would continue with our existing depreciation schedule, but wonder if Bob would get a fractional step up in basis if he inherited, say, 25% of the LLC and the assets of the LLC had increased in value by $200k.

This thought experiment is really showing how little I want to be doing this as I get older each year.
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