Accountants: Sale of Rental Property in LLC - Ordinary Income or Capital Gain?

Question

Dear All,

Are there any wise accountants out there?

The Situation:  The LLC in which I own a 50% interest sold a rental property last year and recorded a large gain on the sale.  I had considered this a "capital gain" and thought it would flow through from my K-1 to personal tax return as such, and as a result, I consciously sold a significant amount of my "under-water"  stocks at a loss to try to "offset" that gain, so as to lower my personal tax liability.

My accountant has informed me that because it was "rental real estate", it is considered a 1231 sale, and as such, it is considered "ordinary income" and not a "capital gain", with the important implication of that being that I am not able to use my stock losses as an offset.  In effect, since it is considered ordinary income, it is in another bucket other than capital gains/losses, so not all of the stock losses can be used.  This has the effect of significantly increasing my tax liability.

Any thoughts/comments on this situation, and has anyone experienced this similar issue?  Is there any legal/accounting interpretation/loophole which would allow for that sale to be considered a "capital gain" so that I can utilize my stock losses as an offset?

Any input from the informed BP Nation would be greatly appreciated!

Brandon Hall · Answer

@Cal C. @Steve Vaughan Sorry for just now getting to this. Tax season is weighing me down! Thanks for pulling me in.

@Matthew Schroeder rental real estate is Section 1250 property. Section 1231 basically just refers to whether the asset is eligible for favorable capital gains treatment. Since you held the property for less than one year, it is not eligible for Section 1231, and as such, your long term losses from stocks cannot offset your gains from the sale of your property and you can only deduct $3,000 of the long term losses. The rest of the loss will carry over until used. The gains from the sale of your property are taxed at your marginal rate.

Did you discuss the sale of your holdings with your accountant prior to taking action?

Gene Mitchell · Answer

I also am not an accountant, but I think your acct is incorrect. Should be a capital gain. Don't forget that you must recapture any depreciation on figuring the gain.

James Wiltz · Answer

Hello BP Help,

Refreshing the above question, perhaps it applies to several members.  Thank you all,

Jon Hazeltine · Answer

I thought I would reopen this since I have an almost identical situation.

1.  I just sold a property that was owned by an LLC of which I am a 50% partner.

2. The property was rented for over 5 years.

3. There are substantial capital Gains.

Here are my questions:

1. Will it be taxed as long term capital gains? (I assume it will)

2. Since the LLC is a 50% partnership, does that mean that I will be responsible for 50% of the capital gains?

3.  Can capital losses be used to offset these gains  and if so, are they offset from losses in the LLC or are they offset by the individual members of the LLC? examples here would be helpful.

Matthew Schroeder · Answer

All,

Thank you very much for your input!  The BP Nation is definitely an informed group of professionals!

After more research & further consultation with my accountant, the explanation which Brandon Hall outlined pretty much summarized it.  The  fundamental issue in my specific case was that the LLC held the property for < 1 year.  It is really unfortunate as, to make a long story short, I actually previously held the property in my own name for greater than 1 year, and then quit claimed it to the LLC, after which the LLC sold it within a couple of months.

And, in answer to Brandon's question, no unfortunately I/We did not consult our accountant prior to taking the action because around the time of the sale, we were transitioning from our old accountant (who really didn't understand the nuances of real estate), so we didn't have a formal accountant for a few months.

Lesson Learned:  Accurate Tax Planning & a Knowledgeable Accountant are Invaluable!

Once again, thank you very much for your input!

Best,

Matthew

Steve Vaughan · Answer

Thanks for taking the time to clarify for us @Brandon Hall.  We know you are busy!

Steve Vaughan · Answer

I think the key here is held less than a year.  We needed to know that, A short-term cap gain is treated as ordinary income, as far as I know.  Let's ask our helpful expert.  See if he has time to help us minions:)    @Brandon Hall?

Steve Babiak · Answer

First the definition of section 1231 property:

http://www.investopedia.com/terms/s/section-1231.a...

Now links to counter the opinion of the OP's accountant:

http://loopholelewy.com/loopholelewy/15-selling-yo...

http://www.keithbakerlaw.com/documents/TaxLawExpla...

This link is the one your accountant should follow in determining classification of gains and losses:

http://www.cpaexamacademy.com/lessons/regulation-r...

Cal C. · Answer

I'm surprised no accountants have weighed in on this.  Can someone please add a few of the accountants on BP to this thread.  My mention doesn't work.

@Brandon Hall

Matthew Schroeder · Answer

Thank you for the initial feedback.

My accountant seems to be very knowledgeable & diligent, but it seems that the deeper we delve into the nuances & interpretation of the specifics of the tax code, the more unfortunately my tax liability increases.

By the way, I should have mentioned in the details of my initial post that while we are 'buy & hold investors', in this specific case, the property was held for < 1 year - we sold into a market that had a voracious appetite.  But, based on my understanding from the accountant, the fundamental issue is that the IRS considers it as a 1231 sale because it is "rental real estate", and as such, it is considered "ordinary income" (with some consideration for depreciation) - this is irrespective of holding period.

It seems a bit strange/wonky to me, but I am no expert on taxes and the IRS code.

Accountants: Sale of Rental Property in LLC - Ordinary Income or Capital Gain?

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