What to consider when you and your partners have to go separate ways
Last week, we began our multi-part series on the importance of planning for the disposition of commercial real estate properties acquired by multiple, non-family investors. These can include owner/user properties, such as industrial real estate assets, where business partners acquire a building as a home for their business, as well as third-party investor groups who pool their capital to acquire income producing property.
As we discussed in Part 1, most properties are acquired by creating an LLC or Limited Liability Company for the express purpose of acquiring, managing and disposing of a specific asset. The LLC that makes clear the respective interests and responsibilities of each member and spells out the decision-making process as it relates to the operation and disposition of the asset.
While most property LLC’s are similar in structure, each one should be customized to reflect the needs and desires of all the members, including, the all-important rules governing the eventual disposition. As obvious as that might sound, it is often overlooked when the LLC is created, as the parties are focused on the terms and timing of the acquisition and not on what might happen decades in the future when life throws a curveball at one of the members that forces a sale.
In Part 1, we also discussed the concept known as the Drop & Swap, whereby the LLC ownership vesting is “dropped” down to a Tenancy in Common (TIC), which allows individual members to choose their own disposition path, which may include a straight sale or 1031 Tax-Deferred Exchange. Without the TIC, the LLC can exchange, but it must include all the members, which becomes problematic when one or more of the members has to cash out. This methodology becomes especially important when properties have been held for a long time and are highly appreciated. Click here to review last week’s post on this topic.
Let’s take a look at a hypothetical scenario by way of further explanation:
Steve, Rick and Logan became good friends in the 1980’s working for a custom home builder in the summers to help pay for college. Steve learned framing, Rick was on the plumbing crew and Logan helped wire the houses. By the time they graduated, few jobs were available in their fields of study, so they decided to pick up some side jobs together to pay the bills while they job hunted. Simple stuff at first, but before they knew it, they were so busy they didn’t have time to look for other work.
They even bought some fixer-upper homes themselves, did the remodeling work and sold them at a profit, each building up a nest egg in the process. By the mid-1990’s they had their own crews in most of the trades and needed more space for all their equipment and materials. They pooled their cash for a 10% down payment on a 12,000-square-foot building in Anaheim. They paid just $65 per square foot for it and still own it today.
The business did well through the years. They all worked hard and remained good friends, but after four decades their personal lives took them in different directions.
Steve has been married for over 30 years, has three kids, two still in college and one who works for the company. He says he’s got another 10 years in him before retiring because he is grooming his son to take over his share of the business.
Rick married, but never had kids and the couple used their spare time to travel extensively. Unfortunately, he passed away in 2023 after a protracted illness, leaving his share of the business and the building to his wife.
Logan never married, choosing instead to focus on building the construction business and accumulating an impressive personal portfolio of rental homes and multi-family apartment buildings. He still has no plans to retire, but is spending more of his time on his portfolio than on the business, which makes up the bulk of his net worth, which is many times that of his partners.
Logan, smart guy that he is, knew things would eventually change for all of them and he wanted to make sure that each of them was protected from forcing a taxable sale on the other while remaining free to pursue their own interests, staying friends in the process. So, when Rick first fell ill, Logan dissolved the LLC that owned the building and changed the vesting to a Tenancy in Common. This he knew would allow them all to go their separate ways without penalizing one another.
So, early this year they all agreed to sell the building so that Rick’s wife could receive her share in cash, and Steve and Logan could use their respective shares to exchange into individually owned assets. Rick’s wife got a full step-up in basis upon his passing due to California’s status as a community property state, so when the property sold for $410 per square foot, about what it was worth when he died, Rick’s wife received over $1,600,000 in net proceeds without paying a penny in capital gains taxes.
Steve exchanged his share into another home in Lake Tahoe, which he eventually intends to move into as his personal residence when he finally retires. All he needs to do is rent it for 14 days per year for the first two years to keep his exchange intact.
Logan exchanged his share into another multi-family property in Laguna Hills.
The company then took advantage of the soft leasing market in the industrial property sector, and moved into a 9,000-square-foot building in Orange on a three year lease with an option to purchase.
All three principals got exactly what they wanted, when they wanted it, and nobody paid a nickel in taxes, thanks to Logan’s foresight to change the title vesting. Oh, and don’t forget, they each only put $26,000 down to buy the building and split $4,800,000 in equity at the closing, a huge win.
The foregoing is a hypothetical scenario, but it is based on our decades of experience in dealing with business owners like you who find themselves sitting on a gold mine with their partners wondering what to do. Whatever that turns out to be for you, make sure you know the rules and that each of the members of your LLC know them as well as you do. Chances are you will be going in different directions some day and your motivations may not be in complete alignment when that time comes. Good planning can help everyone. No planning will hurt everyone.