How to make sure you keep your options open
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.
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. Let’s take a closer look at this basic dynamic.
The vast majority of property acquisitions are made by Limited Liability Companies (LLC’s) created for the express purpose of acquiring a property. This entity type provides protection of the other personal assets of the parties involved, and establishes the rights, duties, activities and responsibilities of all the parties 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, which are often heirs to the respective estates.
The most commonly overlooked barrier to disposition in LLC structures is the restriction on 1031 exchanges for members of the 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 interests in the property. But, there is a way around the problem, though it takes time and deliberate action. It’s commonly known as a Drop & Swap, whereby the 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, it 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.
So, we recommend that any LLC with multiple members consider exiting their LLC ownership structure to create the flexibility needed for individuals to go their separate ways when the property is ultimately disposed of. That may seem counterintuitive. Why create the LLC in the first place if you’re going to just undo it in the future? The variable in play is time. So, many of you who own properties in an LLC with non-family partners, have held your property for decades, and as we all know, life has a wicked curveball and a darn good slider to go along with a fastball. Things change and we sometimes need to make adjustments. Next week we will look at a hypothetical example of what can go wrong when an LLC comes nose to nose with an unanticipated disposition. Stay tuned.