I'm just beginning to learn about 1031 exchanges, so this is probably a pretty basic question. Husband/wife looking at investment property. Property is currently residential, but in a commercial zone, and may want to convert to commercial in the future. Would like to purchase and finance personally for better loan rates, or can possibly finance entirely with Home Equity loans. Definitely plan on doing a 1031 exchange in the future (also for rental property), and want to make sure that will be possible.
I'm not sure what you mean by finance personally. This is investment property, so you need to finance it with investment financing. You can not finance it as owner occupied if it is investment property, which would be lender fraud, so be careful.
Using a third party financing source, or using your personal funds or HELOC does not matter from a future 1031 exchange perspective. However, there may be differences in terms of income taxes, so consult with your accountant. Using your HELOC essentially means it is an all cash transaction. There are some benefits to acquiring the property initial with a third party loan (purchase money) financing.
1. Will the change from residential rental to commercial rental affect 1031 eligibility?
No, they are both considered to be investment property, so both will qualify for 1031 exchange treatment.
2. If we don't finance personally, and form an LLC instead(not a community property state), would that affect anything? Actually, if we finance personally, and then transfer property into an LLC, would that affect eligibility?
This question can have many legs. It depends (that's my favorite answer).
Generally, no, it will not affect your 1031 exchange eligibility. You can acquire in an LLC and then later when you decide to sell and complete your 1031 exchange the LLC would sell and would also acquire your like-kind replacement property to complete your 1031 exchange. In this case, the LLC is the taxpayer that would be completing the 1031 exchange.
You are not in a community property state, so the two (2) member (husband and wife) LLC would be treated as a partnership. So, as long as the LLC sells the relinquished property and then also acquires the like-kind replacement property to complete your 1031 exchange in the future you will be O.K. The potential issue might be that you sell your relinquished property under the name of the LLC but will not be able to acquire your replacement property under the name of the LLC if a lender refused to finance in the name of the LLC.
3. How can we do this to make sure it stays eligible for an exchange? Do you see any red flags we should be aware of?
One possible structure would be to have each of you set-up your own single member LLC so the property is owned by two (2) single member LLCs (one owned by the husband and one owned by the wife) as tenants-in-common. Single member LLCs are "disregarded entities" and are treated as if the underlying single member is the owner for income tax purposes (a two member husband and wife LLC in a non-community property state is treated as a partnership). This would eliminate any future problems with a 1031 exhange if lenders refuse to lend to the LLC. You could acquire your replacement property in your individual names and still qualify for tax-deferred exchange treatment since the single member LLCs are disregarded.
Let me know if this makes sense or if you would like to talk about it further.
Thanks much in advance!