By Benny L. Kass
Saturday, August 23, 2008

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 house as a rental. I knew that I had three years to sell the house to avoid a capital gain.

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, though it would be a trusted friend. I would 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 a limited liability company that then would buy the house back from our friend for the same price he paid. The friend would make a couple of "mortgage payments," for which he would 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 I suspect that the Internal Revenue Service wouldn't, either.

It seems that you will make a decent profit if you sell your old house and are trying to avoid paying tax on it. 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 ($250,000 for single people or married people filing separately). Because you have moved out, to preserve your right to this great tax benefit, you must sell within three years, as you seem to know.

But you and your wife also want to rent the house, presumably because you believe it to be a good long-term investment.

What you are proposing is a way to try to get the best of both worlds: You would 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 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 other ways to avoid paying the capital gains tax while keeping the property as a rental. One of them is common and perfectly legal, and the other, to my knowledge, has not been tested by the courts or the IRS.

· Starker exchange. Go ahead and turn your old home into a rental. When you eventually decide that it is time to sell, consider a 1031 exchange, also known as a like-kind or Starker exchange. If you meet the 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 the time. The tax basis of the relinquished property will be the basis of the replacement property, but until that new property is sold, you will not owe the IRS 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 use. 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 when you sell.

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 for a number of years.

· Sell to a subchapter S corporation. Up until a decade ago, one of the tax benefits available to homeowners was known as a 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 gain tax. The profit that you made on the old house was rolled over into the new house.

Back when the rollover was in effect, the IRS issued a private letter ruling. That's a written statement that interprets the law as it applies to one specific taxpayer's situation. That letter said that if the homeowners sold their old house to a subchapter 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 rollover rules.

Private letter rulings cannot be used as precedent because they are a specific ruling for the person requesting the opinion. However, they do reflect the thinking process at the IRS.

So instead of trying a less-than-valid "sale" with a straw party, why not consider creating a subchapter S corporation and selling 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 regular payments to you.

If there is a mortgage on your property, you would have to get your lender's permission for 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. (Under your proposed scenario, your lender also could call your loan due, because your friend does not fall within any of the exceptions.)

Limited liability companies didn't exist when that IRS private letter ruling was issued. Perhaps transferring your property to an LLC would also work, but the course of action that is safer -- although still not guaranteed -- would be to sell to a subchapter S.

Consult your legal and financial advisers to make sure you are following all of the corporate rules and regulations.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, http://www.kmklawyers.com.