Non-cash partner - Taxable Event?

Question

I'm trying to structure a California LLC as the non-cash partner. My partners are bringing the cash to the deal. We are building ground-up condos and planning to hold them for rent long term. I found the property and assembled the team, and I will be the managing member of the LLC - and I have negotiated a % of the deal in return. My CPA is telling me that if I take a percentage of equity ownership, that is a taxable event and I will owe taxes on my % of the total capital raised as outlined in the operating agreement (on day 1 before we have built anything!). This is my first partnership multifamily deal after purchasing and renting my own properties, and I'm a bit lost on this topic.

My goal is to have equity ownership, take advantage of depreciation, and hold the property in the LLC long term, while collecting distributions and paying applicable taxes on those distributions.

My intention was to assign % ownership when the entity value was $0, like can be done when founding a company prior to incorporation. Thus no taxable event. Is this possible in a real estate deal, or am I forced to only be a profit sharing member of the LLC, taking distributions but not holding equity?

With so many partnership deals and syndications out there, there must be some proven strategies!

Ashish Acharya · Answer

In a very simple word, if you didn't bring money into the deal, and you are entitled to receive money when the company liquidates (hypothetically) its capital with no basis of yours, then you will have to pay taxes on the money you got for free. An attorney can draft an agreement to avoid capital interest.

- If you dont want a taxable capital interest, your interest should only share future earnings and appreciation attributable to the profit interest. The capital interest participates immediately in some portion of the LLC’s existing value. (If the value is 0, then it doesn't matter. But if assets are contributed, and you are entitled to the portion of the value, then it will create some taxable event).

This is a complicated area and you should work with an attorney and CPA.

James Hedgecock · Answer

@Basit Siddiqi - ok, then I am still missing something! I was told I need basis in the project in order to take the depreciation? I guess it could be assigned to me, but how to use it? If you have any summary or links to an explanation on this I would appreciate it!

Basit Siddiqi · Answer

@James HedgecockActually - you can be given depreciation without any equity ownership.

James Hedgecock · Answer

@Basit Siddiqi thanks! Yep, I think I've got this figured out at this point and better understand the difference between equity ownership and profit sharing % in the LLC agreement. If you want the equity and the depreciation that comes with equity ownership you have to either put in the capital or at some point figure out how to satisfactorily take out your equity partners and replace them with your own capital or debt. Always learning!

Basit Siddiqi · Answer

@James HedgecockThe great thing about partnerships / LLC is that the partnership allocation can be whatever you want for it.There is a difference between capital account / capital percentage and profit /loss percentages.In theory, a partner can put in 0% of the capital but be entitled to 20% of the profit / loss.Best of luck to you.

James Hedgecock · Answer

@Dan Dietz - I wish it was that simple... But assignment of debt can create equity ownership and basis for depreciation, in general. How it applies to your deal, and how much debt as a percentage of other capital and debt, determines your percentage of equity ownership. You may want that to be different than your percentage of future distributions. Each of these can be outlined separately in your operating agreement. (that's my understanding from researching this topic with multiple CPAs thus far, but I am no expert!)

Ashish Acharya · Answer

Remember, bringing sweat equity doesn't grant capital interest right away.

James Hedgecock · Answer

@Ashish Acharya, thank you for the reply. I agree that if you are being given a % of equity that has value for services rendered, it is a taxable event. I think the best way to move forward is with the profit sharing % interest so that I am only taxed on those liquid distributions as they happen.

@Joe Splitrock, thank you, and I agree that in some cases loan(s) from partners instead of equity would make sense. Or a buyout refinance between the construction phase and the permanent financing phase. I believe @Matt Faircloth covers some of this in his BP book, Raising Private Capital. In this case the equity partners are needed to sign personally on the loans, so they have to stay in as equity. But I believe this is a solution to create equity ownership and basis in the deal for a non-cash partner.

BP Community - I know this is a sticky legal/tax topic that is near impossible to solve in the forums and it requires a custom CPA solution for each situation. However, I am very surprised by the amount of BP content in podcasts, books, and online that uses the word "equity" when talking about "sweat equity" partners and capital partners. Countless situations refer to the Non-cash partner as sharing equity % with capital partners, whether in partnerships, LLCs, syndiactions, LPs, etc. This is in contrast to everything I am learning, which is that the money usually owns 100% of the equity and the non-cash partner, general partner, whatever the name is, owns a profit sharing percentage only. These situations are often short term deals, that when made liquid, provide profits to all and are then taxed more easily. But on a long term buy and hold deal, this is a big issue. I wish it was better addressed via a new BP book or an in-depth podcast. Maybe soon!

All comments are welcome as I hope this thread helps others that might struggle with this concept and otherwise get themselves into trouble with the tax implications.

Non-cash partner - Taxable Event?

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