How to make sure you and your partners have maximum flexibility?
Many of you have acquired commercial property with others through the years. Some of you have acquired a building with your business partners to serve as a home for your operation, while others have collaborated with like-minded investors to scoop up income properties for passive income, value appreciation and portfolio diversification.
Either way, if you have collaborated to acquire commercial property, you need to make sure that you and your partners have built in the flexibility to go your separate ways when the time comes, as there are significant tax and estate consequences to prepare for. In this post, we take a look at ownership structure and title vesting to get you thinking about optimizing your exit alternatives just in case life gets in the way and calls on you to take action.
The Importance of Planning Your Exit Strategy
When investors combine resources to acquire property, they do so after conducting due diligence and fully considering the potential benefits and risks associated with the acquisition. They are usually in agreement on what they want to buy and why. However, they often neglect to consider how they will exit the investment, as the eventual disposition is many years in the future. So, understandably, the focus is on structuring the terms of the deal and getting the acquisition over the finish line, rather than the tax and estate consequences of a disposition that might not occur for decades.
Why LLCs Are Commonly Used for Commercial Property Ownership
Most acquisitions are made by Limited Liability Companies (LLC’s), that are created for the express purpose of acquiring a specific property. This entity type provides protection for other personal assets of the LLC members, and establishes the rights, duties, activities and responsibilities of all members involved in the investment. The LLC structure makes perfect sense and is recommended by real estate lawyers, estate planners and financial experts, as well as commercial real estate practitioners like us. If constructed appropriately, the LLC agreement will also address how the property can be disposed of, which at some point, will become essential and consequential to everyone with an ownership interest, who are often the eventual heirs to the respective estates.
The 1031 Exchange Challenge for LLC Members
The most commonly overlooked barrier to disposition in LLC structures is the restriction on 1031 exchanges for members of an LLC who wish to individually exchange their share of the proceeds in a disposition. The 1031 rules allow the LLC in its entirety to exchange into another property that meets the like-kind rule, but the rules disallow individual LLC members to exchange their individual interests into separate properties.
What Is a Drop & Swap?
But there is a way around the problem, though it takes time and calls for deliberate action. It’s commonly known as a Drop & Swap, whereby title to the property is dropped from the LLC structure into a Tenancy in Common ownership vesting before the property is sold. Two things are important here: 1) it removes the liability protections of the LLC and, 2) it delays the sale of the property for at least one tax year to satisfy the IRS that the intention was not to change the vesting for the sole purpose of having members exchange their individual ownership positions. Yes, that seems a little silly, but that’s how the IRS rules have been interpreted. Some accounting professionals even recommend holding the property as Tenants In Common for at least 2 years, just to be sure.
Why Multi-Member LLCs Should Consider Tenancy in Common Ownership
So, we recommend that any LLC with multiple non-family members strongly consider exiting their LLC ownership structure in favor of a Tenancy in Common vesting to create the flexibility needed for individuals to go their separate ways when the property is ultimately disposed of. This is especially important as partners get older and their estate plans and family circumstances become more complex. Also, while the motivation and intentions of the LLC members may be aligned early on, things change and conflicts can result, especially when one or more partners do not wish to realize their gains and pay capital gains taxes, while another needs to sell for personal reasons. The Drop & Swap solves that problem, but only if it has already been done in anticipation of just such a scenario.
The Cost of a Drop & Swap
The only cost involved is for document prep, recording fees and a quick review by your financial and legal advisors to make sure the process passes muster. The unfortunate truth is that most non-family partners in an LLC, even those who know the rules, don’t take this important step in planning for the future. But life circumstances can change quickly, and this simple process can prepare you and your partners for a smooth transition should the unexpected show up at your doorstep.