For real estate investors, placing your property into a business entity can serve as a great tax savings strategy. This allows you to separate properties with different purposes and make sure they receive different tax treatment by the IRS.
Before you take this step, you first need to answer this key question: what classification do you want for this property? The three classifications—that come with different tax treatment—are:
• Investor Status: These properties earn money by slowly growing in value over time. They enjoy the lower capital gains tax rates.
• Dealer Status: These properties aim to go from renovation to sale quickly. They are subject to ordinary income tax rates but have the ability to claim ordinary losses.
• Developer Status: These properties include bare land that is being built on for the first time or a building that is being demolished and rebuilt. Like dealer status properties, they pay ordinary income tax but can also claim ordinary losses.
Now here is where the strategy comes into play: if you have a property that counts as dealer or developer status and another property that you want to have classified as investor status, how do you ensure that the IRS gives them separate tax treatment? The answer is to use different entities for each property status. Today, we’ll discuss the benefits and limitations of two entity types: LLCs and LPs.
LLCs vs LPs
The entity type that is right for you will depend on your unique circumstances and goals. However, limited liability companies (LLCs) and limited partnerships (LPs) are often the preferred vehicles for real estate holdings because of the flexibility and tax benefits that come with them.
LLCs offer:
• Pass-through taxation: Because profits and losses are passed onto the owners, they are taxed at an individual income tax rate, avoiding the double taxation that comes with C corporations.
• Ease of contributions and distributions: Contributing to an LLC is not a taxable event, and distributions are not taxed at the LLC level (but they are taxed at the owner level).
• Flexible allocations: Profits and losses can be distributed to whichever owners would benefit from them most, regardless of their ownership percentage.
• Liability protection: This entity type allows owners to separate their personal assets from their business debts.
LPs also offer flexible allocations, pass-through taxation, and ease of contributions and distributions. However, liability protection can present an issue in a limited partnership. You need at least one general partner, and that person or entity does not have liability protection via the entity itself. One workaround is to form a partnership with a C corporation that you also own and make that C corporation the general partner—a C corporation does come with its own liability protection.
Both LPs and LLCs (when taxed as a partnership) also offer benefits when it comes to deducting losses. To deduct a loss, you need to have sufficient basis—in other words, you cannot deduct more than the amount of your investment in the business. The rules around this are different for partnerships than they are for corporations. For example, with an S corporation, simply having a mortgage on the property does not give us basis. However, it does with a partnership, making it easier to claim a deduction with an LP or LLC.
LPs and LLCs also come with certain drawbacks. A major one is the fact that both entities can leave you subject to self-employment tax. LLCs also tend to be expensive, but limited partnerships can be a more affordable option if you can work with the liability protection issue.
Making Contributions
Because LLCs are taxed as a partnership by default, they come with similar tax advantages to LPs. One is that contributing property to a partnership is typically not a taxable event. So no gain or loss is recognized when you place your property in an LLC or LP in exchange for the partnership interest. However, there are exceptions to that rule when it comes to:
• Encumbered property
• Built-in gain property
• Disguised sales
Encumbered Property
When a partner contributes property that has a liability, like a mortgage, the partnership takes on the debt. This can have an unfortunate side effect for the contributing partner. Because they receive debt relief, that partner is treated as having received a distribution. The result? If the debt relief is greater than the partner’s outside basis (the amount a partner has invested in the partnership), they must recognize a capital gain. That gain is a taxable event.
So let’s say for example that a partner contributes land with a $180,000 mortgage, they have an outside basis of $20,000, and their share of partnership liabilities afterward is $90,000. The $90,000 debt relief exceeds that $20,000 basis, so the partner would have to recognize a $70,000 taxable gain. Keep this in mind when choosing an entity. If your property is subject to a liability, you may want to reconsider contributing it to a partnership unless your calculations show that you would not face a taxable gain.
Built-In Gain Property
A built-in gain happens when the property’s fair market value is higher than the basis when it’s contributed. In this case, the built-in gain stays with the contributing partner. Later, when the property is sold, that gain will be allocated to the contributing partner—in other words, they will be responsible for the tax on the entire profit from that sale. So those who think they can avoid taxes by contributing a property to a partnership should think again. You may be able to delay that tax payment, but it can catch up with you eventually.
Disguised Sales
This problem arises when you contribute property to a partnership, and then within two years, you receive a cash or property distribution from that partnership. The IRS will consider this “disguised sale” because it looks like you only contributed the partnership in order to receive a cash benefit.
To determine if a disguised sale has happened, the courts will try to determine the reason you contributed that property and if there was a deal with the partnership that you would receive a payment in exchange for the property. So if you have a written agreement that says you can withdraw cash from the partnership when you refinance the property next year, that would count as a disguised sale. Because you are receiving income through that sale, you will have to pay tax on it.
Receiving Distributions
Just like with contributions, distributions from a partnership are typically tax-free until you exceed your basis in the partnership—but there are some exceptions. Two other rules that apply are:
• The seven-year rule under §704(c)(1)(B): When a partner contributes property to a partnership, they need to wait seven years before that property can be distributed to a different partner. Otherwise, the original property owner has to recognize built-in gain—and is responsible for paying the tax on any profits when the property is sold.
• The seven-year rule under §737: When a partner contributes property to a partnership, they need to wait seven years before receiving a distribution of other property owned by the company. Otherwise, they have to recognize gain and pay tax on that contribution.
In both of these cases, there is a simple way to avoid an immediate tax bill: wait until after the seven year holding period. To make sure you have your timeline straight, you will want to keep a log that notes:
• The date your property was contributed
• The fair market value of the property on that date
• Your basis in the partnership on that date
Summary
Placing your real estate in an entity can be a wise tax strategy. However, before you do so, you need to familiarize yourself with the pros and cons of each entity choice. Limited partnerships and limited liability companies are popular for a reason—but they do come with notable drawbacks that you want to be prepared to navigate. In particular, make sure that you don’t fall into the trap of contributing an encumbered property, a built-gain property, or a disguised sale. This could result in an unexpected tax bill that undoes the tax savings you had hoped for.
To receive expert guidance in using entities as part of your real estate tax strategy, reach out to a Certified Tax Planner today.
