Real Estate Investing with Partners
I had a Tax Strategy appointment with a new client this past week that was just in time! He and a handful of other partners were about to buy a large commercial property with an LLC they all owned. He said his exit strategy was to eventually sell and then do a like-kind exchange into another property. It’s a good thing that we talked when we did, because he was about to make a mistake that would have cost him the ability to ultimately do the like-kind exchange that he planned.
Can you spot what the mistake was?
In March 2002, the IRS issued a Revenue Procedure with very clear specifics on how partners can own a property together in a way that they can then later have a Section 1031 tax-deferred like kind exchange.
A Section 1031 exchange allows you to defer the gain from the sale of real estate by rolling into another investment property. You can exchange commercial property for residential, single for multiple, bare land for developed and vice versa. But, there is one thing you can’t do - you can’t exchange an investment property for an interest in an investment property. In other words, if you are a member in an LLC (Limited Liability Company) you can’t then exchange that interest into a property of your very own.
Up until 2002, it wasn’t really laid out clearly how you could do do the exchange from multiple ownership to single ownership, or even if you could. That’s when the Revenue Procedure came out laying out clearly the steps required. And, it all started with holding your interest in a property as a Tenant-in-Common (or TIC). You could then do the exchange later of your portion of the property and profits into another property. But, you have to have the property you purchase titled correctly in the beginning. Fail to do that…and you lose a lot of flexibility when it’s time to sell.
The part that’s really shocking to me is that my new client had already talked to another CPA and an attorney, plus he was investing with people who were very sophisticated. Yet, none of them had warned him about the possible problem. Why? Well, it could be they didn’t know. It could be they didn’t care. But, I think it was most likely that no one had asked him the right question yet. “What’s your exit strategy?”
Sometimes people get discouraged with all of the questions we ask initially before you become a client of my CPA firm, especially if you choose to work directly with me. This is a great example of why we do want to know all the details first. It’s the way we work best with you.
If you’d like to learn how you can become a client of one of our referral CPAs, please check out www.DKAffiliated.com and if you’d like to work directly with me, please drop an email to Richard at CPA@TaxLoopholes.com or give him a call at 602.258.0700, extension 5. Please don’t be disappointed though, I only take a few new clients each month. To be considered, please contact Richard right away.
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This may be an obvious question, but I’ll ask anyway for confirmation: If partners are in an LLC and sell a property in the LLC name, then they can use the 1031 Exchange as long as the new property is also purchased in the LLC name? Thanks, Pittsburgh Mike
The LLC, in total, can do an exchange. The issue happens when one of the LLC members wants out - that’s when you need the TIC solution.
Good question. Thanks for asking.
Is it madetory to use a Qualified Intermediary when doing a 1031 exchange?
Thanks!
If you do an exchange directly, you don’t need an Intermediary. For example, let’s say you have an apartment building and I have a commercial building. They have the same value and we swap. That’s a Section 1031 exchange in its purest form.
It gets trickier if there is a delay in the exchange or the exchange isn’t direct. In that case, I sell my apartment building and want another apartment building, but the owner of the 2nd building doesn’t want my building. I need someone to do the exchange. You need someone who is qualified to serve in that position. There are some restrictions (for example you can’t do your own exchange).
I was really glad to read this topic, it’s just like an investment I was considering with some other folks as partners in an LLC, but I wasn’t aware of this issue. Thanks for posting it ! A couple of questions though: I didn’t fully understand the meaning of “The LLC, in total, can do an exchange. ” Does this mean that membership in the LLC could have changed since purchasing the first property, but the entire current membership is entitled to rollover the capital gain into the new property? Does the LLC retain all the capital gain, and any past member who no longer owns a piece of the LLC gives up his rights toward capital gains already realized? Thanks again !
Let’s say you and your friends have ABC LLC. ABC LLC owns an apartment building that is sold. ABC LLC can do an exchange into a new property which will then be owned, again, by the LLC.
Your question that you asked about changing memberships is a possible loophole. There are no clear rules though on whether you can change up the ownership in the LLC as a way for some of the partners to still be able to do an exchange. If you’re doing this, make sure you have good advice to walk you through all the steps. It’s a grey area and that’s what makes the answer so uncertain.