I had a Tax Strategy appointment with a new client that was just in time!
He and a handful of other partners were about to buy a large commercial property with an LLC they all owned.
One of the questions I ask for new ventures is “What is your exit strategy?” It’s my version of “begin with the end in mind.” It surprises some people
He said his exit strategy was to eventually sell and then do a like-kind exchange into another property. It’s a good thing that we talked when we did, because he was about to make a mistake that would have cost him the ability to ultimately do the like-kind exchange that he planned.
Can you spot what the mistake was?
The Challenge with Like Kind Exchanges and Real Estate Partnerships
A Section 1031 exchange allows you to defer the gain from the sale of real estate by rolling into another investment property. You can exchange commercial property for residential, single for multiple, bare land for developed and vice versa. But there is one thing you can’t do – you can’t exchange an investment property for an interest in an investment property.
In other words, if you are a member in an LLC (Limited Liability Company) you can’t then exchange that interest into a property of your very own.
The IRS’s Solution
In March 2002, the IRS issued a Revenue Procedure with very clear specifics on how partners can own a property together in a way that they can then later have a Section 1031 tax-deferred like kind exchange.
Up until 2002, it wasn’t really laid out clearly how you could make the exchange from multiple ownership to single ownership, or even if you could. That’s when the Revenue Procedure came out laying out clearly the steps required.
And, it all started with holding your interest in a property as a Tenant-in-Common (or TIC). You could then do the exchange later of your portion of the property and profits into another property.
But you have to have the property you purchase titled correctly in the beginning. Fail to do that…and you lose a lot of flexibility when it’s time to sell.
The part that’s really shocking to me is that my new client had already talked to another CPA and an attorney, plus he was investing with people who were very sophisticated. Yet, none of them had warned him about the possible problem. Why? Well, it could be they didn’t know. It could be they didn’t care. But I think it was most likely that no one had asked him the right question yet. “What’s your exit strategy?”
Sometimes people get discouraged with all of the questions we ask initially before you become a client of my CPA firm, especially if you choose to work directly with me. This is a great example of why we do want to know all the details first. It’s the way we work best with you.