1031 transfer $500K from my name to my corp. - Will IRS get me ? - Posted by Millie I.

Real Estate Investing
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Posted by JPiper on January 19, 2000 at 24:43:30:

Ray:

Thanks for your further explanation.

What I gather from this is that you were discussing an actual situation, which contained facts that you left out of your original post. I gather that the belt that connects to the pulley which turns the wheel which eliminates the need for a crank was the part I missed! Just kidding Ray. But evidently you left some important facts.

So allow me to just reiterate a few things here. I called my CPA today to ask about the transfer of a property to an entity which in the near term did a 1031 exchange. He was adamantly opposed to the risk of this?.as I suspected he would be. Let alone your original suggestion that the property be deeded to a corp, a 1031 exchange, and then deeded to an LLC. That one drove him wild?.again, as I figured it would. As you know, we can all do pretty much anything we want?.the only question is whether it will stand up on audit. It sounds as if your opinions on what works have not been audited as of yet. In my case the way I would approach this is to see what I have to gain considering the risk of the undertaking. In this case, and in the absence of all the facts?it?s difficult, if not impossible, to see what?s to be gained in such moves by either you or Millie.

Let?s go back to the numbers. I used $50K as the income. You?re quite right?interest expense would need to be deducted. But to compare this we would simply deduct from all the entities with which we are comparing?so it becomes a constant?and therefore that factor is irrelevant. We probably would have other deductions as well?.but they will be constant in what we compare?so therefore it?s not particularly important what the specific number is that we use, as long as we use the same numbers for comparison.

So again?.let?s say the net income from the property is $40K if that makes you feel more comfortable. Let?s say the depreciation is $17K.

Your assumption is that the LLC owns the property. So in this example, the LLC pays $40K to the C corporation as manager?.that is what you said isn?t it? This leaves the LLC with a $17K loss?which passes through to the partners on their personal return. Now the C corporation has a profit of $40K. If that $40K is paid out in salary?the partner has $23K in income subject to personal rates?..AND will have created a social security liability on both the corporation AND the partner. IF you pay the net of $23K out in dividends?it?s subject to tax at the corporate level AND at the personal level. If you attempt to keep in the corporation and subject to the 15% corporate rate?.you?re looking at personal holding company treatments.

Now compare this to holding the property in just the LLC?no corporation involved. There is $23K income which flows through to the partners. No double taxation, no social security tax, no personal holding company consideration. Any way you slice this particular comparison, the latter comes out better.

Ray, if you assume even larger deductions for interest?all that happens is that more is deducted at the LLC level?and less paid to the corporation?which reduces the problems faced at the corporate level. But this structure still loses when compared to the straight LLC.

Now Ray, you can complicate this further by injecting other activities into this corporation. That may be true of your situation, but whether it?s true of Millie?s is something I have no information about. But in reality, whether you are looking at your situation or Millie situation, coming back to basics of the above scenario is worthwhile and helpful.

Millie says she doesn?t want the income on her return. But Ray, did you ask why? We don?t know the answer to that question. But my guess is that she would just like to pay less tax. Do you really think that Millie is going to be content to get that income off her return at the cost of higher taxes?

Ray, are you able to take my above simple examples and show how one REDUCES taxes by moving income to the corporation? And for the purposes of any illustration that you may care to make?.let?s assume that Millie wants her money, just as she would have had if she had organized under just an LLC.

Finally, a personal opinion. The most complicated situations I have been exposed to, the ones I had the most difficulty understanding?.were generally speaking the ones that cost me or lost me the most money. Actually I?m beginning to believe that your scenario really isn?t all that complicated?.but on first reading it successfully passed the ?eyes rolled back in the head? test.

JPiper

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1031 transfer $500K from my name to my corp. - Will IRS get me ? - Posted by Millie I.

Posted by Millie I. on January 17, 2000 at 19:41:39:

OK Ed Garcia and Ray Alcorn, you have the floor. Time to pick on Millie.

I plan to sell several properties totalling around $500K this year. My objective is to buy a commercial property using a C-Corp. How do I go around the tax issue of transfering money from one entity to another?

Millie I.
P.S. Maybe this was a PC type question, but no one was home.

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Re: 1031 transfer $500K from my name to my corp. - Will IRS get me ? - Posted by JHyre in Ohio

Posted by JHyre in Ohio on January 18, 2000 at 16:36:13:

Hi Millie!

Well, I’ve been pretty much AWOL for awhile, but Dave T, Piper, Branstetter and others have pretty much obviated the need for a tax jock…good thing, because between family, work and investing, I’ve got my hands full. I figured I chime in here because this issue is getting rather complicated. To wit:

Millie: I agree with Jim (“Dammit Jim, I’m a doctor, not a mechanic!” Wait, wrong Jim…)- do you REALLY want a C-corp? They are generally LOUSY for holding properties when compared to LLC’s or even S-corps. Check this out. IF your only goal is to convert numerous pieces of personally-held RE into one commercial parcel held by an entity (be it C-corp or LLC), consider the following:

To use 1031 you must “hold” property for investment or for productive use in a trade or business. Trading property you own for qualifying property and then contributing the property tax-free to another entity will cause the IRS to argue that you did not intend to “hold” the property because you contributed it. Similarly, if you contribute the property tax-free to another entity, then the entity exchanges it, the IRS will argue that the entity did not “hold” the property and that the exchange therefore fails.

Fortunately, the IRS has LOST these arguments all three times they took them to court. For practicioners, I refer to the Magnusen and Bolker cases in California and one case in Louisiana (the name of which escapes me). Magnusen and Bolker went to the 9th Circuit of Appeals after the Tax Court ruled for the taxpayers. Both times the 9th Cir. (surprisingly) ruled for the taxpayer, albeit on grounds that were less rational and less favorable than those stated by the Tax Court. Bottom line: 1031 followed by a tax-free contribution/distribution of the propety received OR tax-free contribution/distribution of property followed by 1031 were upheld.

So Millie: Doing 1031, acquiring replacement property and doing tax-free contribution to RELATED (e.g.- you own most or all) LLC or C-corp should work. Similarly, doing tax-free contribution of replacement property then doing 1031 within LLC or corp should work. There is risk, albeit managable risk. The IRS is likely to challenge the transaction if they learn of all the facts- but a good attorney will fight them and should win based on the cases discussed above. Note: You CAN exchange properties in a partnership/LLC but you may NOT exchange partnership or LLC shares themselves for real estate. The fact that you are “related” to your entity does not matter here, because you are not creating losses or deductions. Piper is correct in that the existence of related parties means the IRS will be more likely to scrutinize the transaction- but if properly sctructured, that scrutiny should not have a bad result. Furthermore, there are strong arguments against 1031 and potential taxation of contribution where NON-related entities are involved based on the facts you’ve given us. BOTH Bolker and Magnusen involved related entities.

Millie, re your LLC questions: LLC’s do not pay taxes seperate from their owners- sorry. If you are seeking the “income splitting” benefits (e.g.- 15% bracket) of a C-corp for this property, you need to mix the property with a LARGER active business in the C-corp. Otherwise, you run into personal-holding company and forced distribution issues that create double-taxation whether or not you actually distribute. Holding a passive propety in a C-corp alone is a TERRIBLE idea. Holding passive property with an active business can be dicey- probably not worth the taxes saved. I’d use an LLC.

Ray’s management fee idea has merit to bail earnings from an LLC into a C-corp. BUT the management fees MUST be resonable or the ENTIRE transaction could unravel. Making the management fees equal to the LLC’s income or cash flow or any other “rigged” number is probably NOT reasonable- I do not recommend that. See what management companies charge, and have your LLC charge at or a little above the high end. Use other devices for similar effect- maybe your corp can loan the LLC money (but WATCH OUT that the corp has MORE active business income than passive interest income!), etc.

Speaking of Ray’s transaction: it is designed to effectuate a different purpose than what I think you have in mind. He is effectively shifting ownership of property while avoiding the tax consequences of having done so. That is accomplished by muddying the facts- profit shares w/o capital interests, interposition of a c-corp (Ray: I’m not sure that was necessary, but then I don’t know all of the facts either), transfer to an LLC. With the exception of the structure of the management fees (Ray, do they ALWAYS equal cash flow? That would bother me and in my opinion constitutes a weak spot in your structure) Ray’s structure makes sense for HIS (probable) intent- it is also riskier than what I described above. Not guaranteed, but not foolproof either. Chances are that the IRS will not catch it (e.g.- audit lottery), but if they do, there’s gonna be a fight- my guess as to the outcome depends upon the % of interests transfered to others and exactly how it was done and when it was done. Very complicated stuff.

Well, I’m rambling and currently half brain dead (putting me at 50% above my wife’s estimate of my usual capacity). Hopefully I’ve addressed the issues presented. If not, one of you all is certain to let me know (if experience is a guide, this means YOU, Piper!).

John Hyre

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You really need JHyre, but I’ll muddy the water until he gets here! - Posted by ray@lcorn

Posted by ray@lcorn on January 18, 2000 at 12:53:48:

Millie,

I’ll take a run at this, but I would suppose that Piper, Garcia and others may shoot me down in flames. John Hyre may have info that will make me rethink what I have already done!

Form a C corp with ownership that mirrors the present ownership of your properties. In other words, if you own the properties 100% personally, then you should own 100% of the stock in the corp.

Assuming further that you now own the properties personally(?), deed them into the C corp with a value of the amount of basis you currently have in them. Since you own the corp, there is no taxable sale. (This type of transfer is also exempt from transfer recording fees in VA, don’t know about IL)

Then use the corp to do the sales as a 1031 tax-DEFERRED exchange. Acquire the commercial property with the same corp within the parameters of the 1031. After completing the 1031, then transfer the commercial property into an LLC at basis value, with the corp serving as the managing member and owning the controlling share of the LLC, and perhaps you and your husband as the other members. This is a little tricky as far as how far you can push the ownership structure into other hands and still preserve a tax-free transfer. We have also split the ownership interest in the LLC between the corp and several individuals, and avoided a taxable sale when deeding into the LLC by granting the individual members only a profits interest in the LLC. That means that all equity that exists at the time of transfer remains the property of the corp, but future appreciation and profits accrue to the benefit of the profits-interest members. In this particular case it is to your benefit to sign a personal guarantee on any loan to the LLC, as that accrues to your basis. You may only draw cash out of the LLC personally to the extent of that basis.

Pay the corp a management fee from the LLC roughly equal to the pre-tax cash flow. The depreciation deductions should create a loss in the LLC that will flow through to the members on a K-1. That partially shelters the management fee income to the corp and gives you a taxable loss individually. Depending on the total income and the other activities of the corp, the corp may be taxed at a lower rate than you personally. (15% on the first $50T isn’t it?)

If you just really don’t want to appear personally on the taxes, then you can make the LLC a single-member LLC with the corp as the member, and still use the management fee, but the taxable income in the corp will be higher this way.

Confused yet? I am. I have to get my controller and CPA to explain what the he** we have done everytime I file my taxes.

Please do not take this as advice. I am not an attorney or an accountant, and have no desire to be either. Your individual situation may negate the possibility of using any of these strategies. Now tear me up guys!

ray

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Re: 1031 transfer - Posted by JPiper

Posted by JPiper on January 17, 2000 at 20:59:03:

Well I?m not Ed Garcia or Ray Alcorn?but I?m sure they?ll be along shortly.

A few quick thoughts though. I caught myself wondering why you would want your property in a C corporation, since it is a property primarily to be held I presume. I?m sure you must have given this some thought?.but off the top of my head and without knowing your situation, this would be the last type of organization I would want for a property that I held.

Next, if your intent was to sell your properties and then exchange the funds into a commercial property to be bought by this corporation?.forget it. The IRS will eat you alive.

The exchange process has to be followed pretty much to the letter. Therefore, this transfer of property to the corporation should take place either before or after the exchange?no question about that. Don?t mix the two.

The next thing though is that transferring the ownership of property between two entities in what is NOT an arms-length transaction is not a simple transaction. The IRS can look at these VERY closely, because the idea is that someone who can manipulate the ownership of property could do so in order to beat the IRS out of taxes?.something they tend to be concerned with. Therefore, this should be carefully evaluated by your CPA. Again, this transfer should not be mixed with the 1031 exchange.

Then there?s the question of ?when? the transfer should take place?if it is to take place. Personally, I would want it to happen AFTER the exchange?..I would want nothing to interfere with the exchange process. And I would want this transfer to occur long enough after the exchange that the IRS would not have a problem with it. I don?t know what that time is?and obviously the IRS doesn?t know exactly either. Ask your CPA to check the tax cases?see if the answer is there.

JPiper

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Rube Goldberg?? - Posted by JPiper

Posted by JPiper on January 18, 2000 at 14:38:15:

Ray:

Okay, let?s look at some numbers.

The way you want to do this is to end up after considerable shifting with an LLC owning the property. The LLC pays out it?s income to a C corp (management company)?..thereby creating a loss in the amount of depreciation. So let?s say that this property is a $500K property, with NOI of $50K (10 cap). This means that you create a net loss in the LLC of let?s say $17K?.which reduces your personal net income by $17K. The corporation on the other hand earns $50K?.which will be taxed at 15%. HOWEVER, that rate is only true IF no money is paid out of the corporation. If a $50K salary is paid, this offsets the $17K loss?.leaving a net income individually of $33K This will be taxed at the individual rate PLUS social security taxes at both the corporate and individual level.

We could do this differently. We could pay some of this as dividends. To illustrate the effect, lets assume it?s all dividend?thereby eliminating social security taxes. In this case the corporation pays that 15% on $50K?and you pay individually on $50K of dividend income.

Now let?s take this a different way. Let?s assume that you hold the property in an LLC. We have the same $50K net income?less $17K depreciation?.leaving $33K in net income which flows through to the individual return. The difference here is that no self-employment tax is paid at all?and there is no double taxation from paying dividend income.

Ray?I don?t know about you?.but that Rube Goldberg contraption you put together doesn?t look like it comes out as well as the simple procedure of putting the property in a LLC. Perhaps though you can enlighten me as to what I?m missing.

As to the entire idea of deeding to a corporation, which does an exchange?and then deeds to an LLC and then manages the LLC?..yikes Ray?.you?re creating an awful lot of potential problems?aside from the negative ongoing tax consequences. Why bother? I?m not even sure you can deed to a corp and then immediately do an exchange. If you?re going to do it your way, just deed to the LLC. For me?I would rather wait until the exchange is over?.that idea of upsetting the boys at the IRS is entirely unappealing to me?.and they will look to see if this whole set up is just a sham to avoid taxes undertaken by non arms-length entities.

JPiper

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Re: 1031 transfer - Posted by Millie I.

Posted by Millie I. on January 18, 2000 at 04:07:26:

Thanks Jim,

I had a feeling that would not be a good idea, but that was just a thought. Maybe I should be using an LLC for the commercial, but I really want to put it in a seperate tax id. How do big LLC pay taxes? Do they ever pay taxes independant from the partners personal income taxes? there has to be a way.

Millie I.

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Only because Rube built the tax code! - Posted by ray@lcorn

Posted by ray@lcorn on January 18, 2000 at 23:13:33:

Jim,

Thanks for the laugh! I knew that would send you into a brain warp. It does me everytime my guys tell me what we did, but I assure you that if there is a problem in the structure it is in my terrible explanation. I can’t take the credit for this “contraption”, as our team took weeks to plug all the holes. But as John Hyre surmised, we have quite a bit more going on than I am willing to get into here. Suffice it to say that when the dust settles, we are in better shape than when we started.

I probably shouldn’t have laid out such a dastardly complex plan, but Millie really needs to do some out of the box type thinking, and get some professional help, to do what she wants to do. I had visions of her taking my post to a CPA and saying “How do I do this?” I’d love to be a fly on that wall just to see the guys look of disbelief.

John Hyre picked up the gist of my intent, and my comments back to him may help here. I believe that same day transfers will hold up in a 1031, and have done them on numerous occasions. I defer to John’s case cites on the issue, and am glad to know they are out there. I may need them!

Next is the fact that Millie doesn’t want the income on her return, so the easiest way around that is a management fee to a wholly owned corp. The corp doesn’t make the $50T you use in your example because you are confusing NOI with taxable income, which is after interest expense. I assumed debt, and lots of it, but did not make that clear. (I also left out the cash-out refi of the commercial property in the LLC during the transfer from the corp.) I stated that it would depend on other activities in the corp to preserve the tax rate. What I left out is that among the other activities in the corp would be typical cash mangement measures that allow shareholders of closely held corporations to draw cash out tax free, whether through loans, expenses, salaries, fees or other mechanisms. Dividends and double taxation are real possibilities, but only if you don’t plan ahead. This gets tricky, and as I know you are well aware, is not for the unschooled. I consider it my personal mission to reduce our corporate tax liability to zero if at all possible, though that is getting harder and harder to do.

In my deal using your NOI, the cash flow on the property would be about $15T that would be the target to be paid to the corp as a management fee, subject to market conditions as John pointed out. The individual profit interests members get a deduction of their pro rata share of the $17T depreciation. The corp as managing member and with an equity interest only gets only a nominal 1% of the deduction, as the rest flows through to the profits interest members. The corp claims the income along with other income from other activities, subject to deduction and adjustment as may be appropriate to determine the corp’s taxable income. The whole issue of separating the profit interest from the equity interest is accomplished with a clause in the LLC operating agreement.

I’m probably doing a real botch job on explaining this, and will deserve any crticism you would like to level. My real point is to motivate Millie into taking her situation to a professional and structure some plausible alternatives beyond just doing a swap. If you don’t do something different with the operation of the properties, 1031’s become a real albatross after a while. I’m living with some now!

With warmest regards,

ray