Real estate can be a lucrative investment—especially if the owners do advance planning to maximize tax savings. As a tax professional, a top recommendation you can make to your investor clients is to place different properties in different entities. This allows your client to receive different tax treatment for each property and can be especially useful if the properties have differing income strategies.
When it comes to tax treatment, the first consideration is whether these properties will be classified as investor, dealer, or developer status.
Investor status properties earn money simply by appreciating in value over time. So the goal is not to redevelop or sell the property right away. This is typically the most tax-advantaged status, since investor properties enjoy capital gains tax rates.
Dealer status and developer status properties are actively being built up or renovated with the goal of immediately putting that improved property on the market. Dealers might use the “fix and flip” strategy to make a sale, while a developer may build on bare land or demolish an old building and put up a new development. Both dealers and developers face ordinary income tax rates, but they also enjoy certain benefits like the ability to claim ordinary losses.
If your client owns both investor status and dealer or developer status properties, an important strategy is to ensure these are taxed separately by the IRS. You can accomplish this by placing the properties in different entities. Two popular entity choices we’ll discuss today are limited liability companies (LLCs) and limited partnerships (LPs).
LLCs vs LPs
Because LLCs are taxed as a partnership by default, they offer very similar benefits to LPs. First is flexible allocations. Unlike other entity types where profits and losses must be distributed according to each owner’s ownership percentage, LLCs can distribute income, tax credits, and deductions according to what would benefit each partner.
LLCs taxed as a partnership also enjoy pass-through taxation. Unlike a C corporation that faces the dreaded double taxation dilemma, LLCs pass income onto the owners who then pay their individual income tax rate. This also means that contributions (including real property) to an LLC are not considered a taxable event.
One way that LLCs and LPs differ is in terms of liability protection. An LLC inherently enables owners to separate their personal assets from business debts. However, limited partnerships operate differently. Limited partners are automatically protected, but an LP requires at least one general partner—and that partner does not receive liability protection through the LP. One possible workaround is to make a C corporation the general partner. If your client already owns a C corporation or is willing to set one up, that entity will provide them with protection.
Another benefit that LLCs and LPs share involves deducting losses. For both entities, having a mortgage on the property creates basis, which can allow the partners to deduct more losses than they could otherwise. This gives LLCs and LPs an advantage over S corporations, for instance, which do not receive basis through a mortgage.
LPs and LLCs also share disadvantages, such as the fact that both entities can leave your client subject to self-employment tax.
Making Contributions
Fortunately, the act of contributing a property to an LP or LLC (that is taxed as a partnership) is not typically considered a taxable event. However, there are several exceptions to that rule to keep an eye out for. You will want to ask your clients the right questions to make sure they don’t fall into any of these tax traps:
The first trap involves encumbered property, or property that is subject to debt. When that property is contributed to a partnership, the partnership assumes that debt. This might seem like good news to the taxpayer at first, but it comes with a hidden tax consequence: because the contributing partner receives tax relief, the IRS treats that as a distribution. That distribution will be equal to the amount of debt relief minus their partnership share of the liabilities. If the debt relief exceeds the partner’s outside basis in the partnership, guess what? Your client must recognize a capital gain.
The question to ask in this case is simple: does the property you want to contribute to the partnership have a mortgage or any other liability attached to it?
The second trap involves properties with a built-in gain. If the property’s fair market value is higher than the contributor partnership basis when it’s contributed, the contributing partner gets stuck with a built-in gain. This means that when the property is sold, the gain that was not initially recognized will be allocated to the contributing partner. So you want to make sure your client understands that they cannot avoid a gain simply by contributing the property to a partnership.
In doing your due diligence, you should be determining the difference between the property’s current fair market value and the partner’s basis. By contributing the property in a different year or figuring out a way to increase your client’s partnership basis, you might be able to avoid this problem.
Lastly, you can run into problems with disguised sales. If your client contributes property to a partnership and within two years they receive a cash or property distribution from that partnership, the IRS can deem that a “disguised sale.” To determine if this is the case, the courts will use the “but-for” test and the entrepreneurial risk test. The question is whether the partner is only contributing the property to avoid reporting the gain. So the court is looking for some agreement between the partners, like a plan to withdraw cash when they refinance the property within two years. This would unfortunately qualify as a disguised sale, and the contribution would result in a taxable gain.
The question here is to look into how the partnership deal is structured and ask your client if they are comfortable waiting until that two-year mark has passed before receiving distributions?
Receiving Distributions
Distributions from a partnership also come with significant tax benefits—namely that they are tax-free to the extent of the partner’s basis. However, there are some exceptions. Both IRC §704(c)(1)(B) and IRC §737 feature a “seven-year rule” that affects distributions:
- §704(c)(1)(B): If the partnership distributes contributed property to a different partner within seven years of the original contribution, then the contributing partner has to recognize built-in gain.
- §737: If the contributing partner gets a distribution of other property within seven years of the day that they contribute, then they have to recognize gain equal to the lesser of either:
a: The amount that the fair market value exceeds their outside basis, or
b: The partner’s pre-contribution gain
There is a simple way to avoid both of these situations that would trigger a taxable gain: wait until after the seven year holding period before making the distribution. To avoid running afoul of that gain trigger, keep a log that notes the date when the property was contributed, the fair market value of the property on that date, and the partner’s basis on that date.
Summary
Saving tax on real estate investments can require some advanced tax strategies including leveraging entities. Your knowledge of the benefits and limitations of different entity types, such as LLCs and LPs, can go a long way in saving your clients stress and money. Your expertise can also prevent your clients from going for a popular entity choice without realizing they may not qualify for the benefits. To increase your understanding of advanced tax strategies, sign up to Become a Certified Tax Planner today.
