Development

Category: 1031 Exchange General

  • Revive a 1031 Exchange Opportunity Through Rescission

    Often times, a 1031 qualified intermediary (QI) will receive a panicked phone call from a taxpayer who closed the sale of their relinquished property, received the sale proceeds and then realized they could have deferred substantial taxes in a Section 1031 exchange. In many of these instances there may not be an opportunity to revive the exchange, however, in some cases, the taxpayer may be able to breathe new life into what was thought to be a lost cause.
    Can you do a 1031 exchange after closing?
    The use of rescission has long been recognized in law generally in connection with transactions not related to 1031 exchanges. However, the Internal Revenue Service (“IRS”) has allowed the use of rescission to correct a problem with an exchange transaction. “Rescission” is not defined in the Internal Revenue Code or the Treasury Regulations, which are the source of most rules used to advise taxpayers. Rather, rescission is a concept which some courts have allowed, and the IRS has blessed, specifically in Penn v. Robertson, 115 F2d 167, 40-2 U.S. Tax Cas. (CCH) P. 9707 (CCA 4th Cir. 1940).
    As an example, consider an individual taxpayer closes the sale of a parcel of land in February 2020 for a sizable gain. The taxpayer receives the sale proceeds but later finds out they could have deferred substantial tax liability by doing a 1031 exchange. As long as the taxpayer makes the decision to rescind the transaction in the same tax-reporting period–in this example before 2020 year-end–the taxpayer can contact the buyer and they can agree to rescind the transaction. Of course, should the buyer not be willing to cooperate, or should there be a buyer’s lender who does not wish to participate, this process may not be feasible.
    Seller and buyer agree to rescind. What happens next?
    When a rescission is properly completed, the IRS treats the sale as if it never happened, as long as the taxpayer receives the property back from the buyer and the buyer receives the full purchase price back from the taxpayer on or before the end of the tax reporting period for the taxpayer. The parties may agree they were laboring under mutual mistake of fact or some other reason for the decision to rescind. Another important consideration is when the rescission of the transaction is complete, the parties should have no further obligations to each other to take any further action. If these criteria are met, pursuant to the authorities cited above, the parties are in the exact position they were prior to the sale. The taxpayer and the buyer can then undertake another sale and purchase transaction and close the transaction with the participation of a QI company, like Accruit, receiving the exchange proceeds so it can help process the taxpayer’s 1031 exchange. In order to ease the burden on the buyer during rescission, it may be helpful if the taxpayer agrees to pay for any buyer expenses incurred in accommodating the taxpayer.
    Typically, the QI company is not in a position to provide legal advice regarding the rescission process or provide any rescission agreement. There are numerous attorneys and CPA’s nationwide who are knowledgeable in this area of the law and who can help advise the taxpayer.
    Do you have an uncommon situation that you have questions about? https://www.accruit.com/contact-us”>Ask our experts. 
     

  • Revive a 1031 Exchange Opportunity Through Rescission

    Often times, a 1031 qualified intermediary (QI) will receive a panicked phone call from a taxpayer who closed the sale of their relinquished property, received the sale proceeds and then realized they could have deferred substantial taxes in a Section 1031 exchange. In many of these instances there may not be an opportunity to revive the exchange, however, in some cases, the taxpayer may be able to breathe new life into what was thought to be a lost cause.
    Can you do a 1031 exchange after closing?
    The use of rescission has long been recognized in law generally in connection with transactions not related to 1031 exchanges. However, the Internal Revenue Service (“IRS”) has allowed the use of rescission to correct a problem with an exchange transaction. “Rescission” is not defined in the Internal Revenue Code or the Treasury Regulations, which are the source of most rules used to advise taxpayers. Rather, rescission is a concept which some courts have allowed, and the IRS has blessed, specifically in Penn v. Robertson, 115 F2d 167, 40-2 U.S. Tax Cas. (CCH) P. 9707 (CCA 4th Cir. 1940).
    As an example, consider an individual taxpayer closes the sale of a parcel of land in February 2020 for a sizable gain. The taxpayer receives the sale proceeds but later finds out they could have deferred substantial tax liability by doing a 1031 exchange. As long as the taxpayer makes the decision to rescind the transaction in the same tax-reporting period–in this example before 2020 year-end–the taxpayer can contact the buyer and they can agree to rescind the transaction. Of course, should the buyer not be willing to cooperate, or should there be a buyer’s lender who does not wish to participate, this process may not be feasible.
    Seller and buyer agree to rescind. What happens next?
    When a rescission is properly completed, the IRS treats the sale as if it never happened, as long as the taxpayer receives the property back from the buyer and the buyer receives the full purchase price back from the taxpayer on or before the end of the tax reporting period for the taxpayer. The parties may agree they were laboring under mutual mistake of fact or some other reason for the decision to rescind. Another important consideration is when the rescission of the transaction is complete, the parties should have no further obligations to each other to take any further action. If these criteria are met, pursuant to the authorities cited above, the parties are in the exact position they were prior to the sale. The taxpayer and the buyer can then undertake another sale and purchase transaction and close the transaction with the participation of a QI company, like Accruit, receiving the exchange proceeds so it can help process the taxpayer’s 1031 exchange. In order to ease the burden on the buyer during rescission, it may be helpful if the taxpayer agrees to pay for any buyer expenses incurred in accommodating the taxpayer.
    Typically, the QI company is not in a position to provide legal advice regarding the rescission process or provide any rescission agreement. There are numerous attorneys and CPA’s nationwide who are knowledgeable in this area of the law and who can help advise the taxpayer.
    Do you have an uncommon situation that you have questions about? https://www.accruit.com/contact-us”>Ask our experts. 
     

  • Revive a 1031 Exchange Opportunity Through Rescission

    Often times, a 1031 qualified intermediary (QI) will receive a panicked phone call from a taxpayer who closed the sale of their relinquished property, received the sale proceeds and then realized they could have deferred substantial taxes in a Section 1031 exchange. In many of these instances there may not be an opportunity to revive the exchange, however, in some cases, the taxpayer may be able to breathe new life into what was thought to be a lost cause.
    Can you do a 1031 exchange after closing?
    The use of rescission has long been recognized in law generally in connection with transactions not related to 1031 exchanges. However, the Internal Revenue Service (“IRS”) has allowed the use of rescission to correct a problem with an exchange transaction. “Rescission” is not defined in the Internal Revenue Code or the Treasury Regulations, which are the source of most rules used to advise taxpayers. Rather, rescission is a concept which some courts have allowed, and the IRS has blessed, specifically in Penn v. Robertson, 115 F2d 167, 40-2 U.S. Tax Cas. (CCH) P. 9707 (CCA 4th Cir. 1940).
    As an example, consider an individual taxpayer closes the sale of a parcel of land in February 2020 for a sizable gain. The taxpayer receives the sale proceeds but later finds out they could have deferred substantial tax liability by doing a 1031 exchange. As long as the taxpayer makes the decision to rescind the transaction in the same tax-reporting period–in this example before 2020 year-end–the taxpayer can contact the buyer and they can agree to rescind the transaction. Of course, should the buyer not be willing to cooperate, or should there be a buyer’s lender who does not wish to participate, this process may not be feasible.
    Seller and buyer agree to rescind. What happens next?
    When a rescission is properly completed, the IRS treats the sale as if it never happened, as long as the taxpayer receives the property back from the buyer and the buyer receives the full purchase price back from the taxpayer on or before the end of the tax reporting period for the taxpayer. The parties may agree they were laboring under mutual mistake of fact or some other reason for the decision to rescind. Another important consideration is when the rescission of the transaction is complete, the parties should have no further obligations to each other to take any further action. If these criteria are met, pursuant to the authorities cited above, the parties are in the exact position they were prior to the sale. The taxpayer and the buyer can then undertake another sale and purchase transaction and close the transaction with the participation of a QI company, like Accruit, receiving the exchange proceeds so it can help process the taxpayer’s 1031 exchange. In order to ease the burden on the buyer during rescission, it may be helpful if the taxpayer agrees to pay for any buyer expenses incurred in accommodating the taxpayer.
    Typically, the QI company is not in a position to provide legal advice regarding the rescission process or provide any rescission agreement. There are numerous attorneys and CPA’s nationwide who are knowledgeable in this area of the law and who can help advise the taxpayer.
    Do you have an uncommon situation that you have questions about? https://www.accruit.com/contact-us”>Ask our experts. 
     

  • Revive a 1031 Exchange Opportunity Through Rescission

    Often times, a 1031 qualified intermediary (QI) will receive a panicked phone call from a taxpayer who closed the sale of their relinquished property, received the sale proceeds and then realized they could have deferred substantial taxes in a Section 1031 exchange. In many of these instances there may not be an opportunity to revive the exchange, however, in some cases, the taxpayer may be able to breathe new life into what was thought to be a lost cause.
    Can you do a 1031 exchange after closing?
    The use of rescission has long been recognized in law generally in connection with transactions not related to 1031 exchanges. However, the Internal Revenue Service (“IRS”) has allowed the use of rescission to correct a problem with an exchange transaction. “Rescission” is not defined in the Internal Revenue Code or the Treasury Regulations, which are the source of most rules used to advise taxpayers. Rather, rescission is a concept which some courts have allowed, and the IRS has blessed, specifically in Penn v. Robertson, 115 F2d 167, 40-2 U.S. Tax Cas. (CCH) P. 9707 (CCA 4th Cir. 1940).
    As an example, consider an individual taxpayer closes the sale of a parcel of land in February 2020 for a sizable gain. The taxpayer receives the sale proceeds but later finds out they could have deferred substantial tax liability by doing a 1031 exchange. As long as the taxpayer makes the decision to rescind the transaction in the same tax-reporting period–in this example before 2020 year-end–the taxpayer can contact the buyer and they can agree to rescind the transaction. Of course, should the buyer not be willing to cooperate, or should there be a buyer’s lender who does not wish to participate, this process may not be feasible.
    Seller and buyer agree to rescind. What happens next?
    When a rescission is properly completed, the IRS treats the sale as if it never happened, as long as the taxpayer receives the property back from the buyer and the buyer receives the full purchase price back from the taxpayer on or before the end of the tax reporting period for the taxpayer. The parties may agree they were laboring under mutual mistake of fact or some other reason for the decision to rescind. Another important consideration is when the rescission of the transaction is complete, the parties should have no further obligations to each other to take any further action. If these criteria are met, pursuant to the authorities cited above, the parties are in the exact position they were prior to the sale. The taxpayer and the buyer can then undertake another sale and purchase transaction and close the transaction with the participation of a QI company, like Accruit, receiving the exchange proceeds so it can help process the taxpayer’s 1031 exchange. In order to ease the burden on the buyer during rescission, it may be helpful if the taxpayer agrees to pay for any buyer expenses incurred in accommodating the taxpayer.
    Typically, the QI company is not in a position to provide legal advice regarding the rescission process or provide any rescission agreement. There are numerous attorneys and CPA’s nationwide who are knowledgeable in this area of the law and who can help advise the taxpayer.
    Do you have an uncommon situation that you have questions about? https://www.accruit.com/contact-us”>Ask our experts. 
     

  • Revive a 1031 Exchange Opportunity Through Rescission

    Often times, a 1031 qualified intermediary (QI) will receive a panicked phone call from a taxpayer who closed the sale of their relinquished property, received the sale proceeds and then realized they could have deferred substantial taxes in a Section 1031 exchange. In many of these instances there may not be an opportunity to revive the exchange, however, in some cases, the taxpayer may be able to breathe new life into what was thought to be a lost cause.
    Can you do a 1031 exchange after closing?
    The use of rescission has long been recognized in law generally in connection with transactions not related to 1031 exchanges. However, the Internal Revenue Service (“IRS”) has allowed the use of rescission to correct a problem with an exchange transaction. “Rescission” is not defined in the Internal Revenue Code or the Treasury Regulations, which are the source of most rules used to advise taxpayers. Rather, rescission is a concept which some courts have allowed, and the IRS has blessed, specifically in Penn v. Robertson, 115 F2d 167, 40-2 U.S. Tax Cas. (CCH) P. 9707 (CCA 4th Cir. 1940).
    As an example, consider an individual taxpayer closes the sale of a parcel of land in February 2020 for a sizable gain. The taxpayer receives the sale proceeds but later finds out they could have deferred substantial tax liability by doing a 1031 exchange. As long as the taxpayer makes the decision to rescind the transaction in the same tax-reporting period–in this example before 2020 year-end–the taxpayer can contact the buyer and they can agree to rescind the transaction. Of course, should the buyer not be willing to cooperate, or should there be a buyer’s lender who does not wish to participate, this process may not be feasible.
    Seller and buyer agree to rescind. What happens next?
    When a rescission is properly completed, the IRS treats the sale as if it never happened, as long as the taxpayer receives the property back from the buyer and the buyer receives the full purchase price back from the taxpayer on or before the end of the tax reporting period for the taxpayer. The parties may agree they were laboring under mutual mistake of fact or some other reason for the decision to rescind. Another important consideration is when the rescission of the transaction is complete, the parties should have no further obligations to each other to take any further action. If these criteria are met, pursuant to the authorities cited above, the parties are in the exact position they were prior to the sale. The taxpayer and the buyer can then undertake another sale and purchase transaction and close the transaction with the participation of a QI company, like Accruit, receiving the exchange proceeds so it can help process the taxpayer’s 1031 exchange. In order to ease the burden on the buyer during rescission, it may be helpful if the taxpayer agrees to pay for any buyer expenses incurred in accommodating the taxpayer.
    Typically, the QI company is not in a position to provide legal advice regarding the rescission process or provide any rescission agreement. There are numerous attorneys and CPA’s nationwide who are knowledgeable in this area of the law and who can help advise the taxpayer.
    Do you have an uncommon situation that you have questions about? https://www.accruit.com/contact-us”>Ask our experts. 
     

  • Revive a 1031 Exchange Opportunity Through Rescission

    Often times, a 1031 qualified intermediary (QI) will receive a panicked phone call from a taxpayer who closed the sale of their relinquished property, received the sale proceeds and then realized they could have deferred substantial taxes in a Section 1031 exchange. In many of these instances there may not be an opportunity to revive the exchange, however, in some cases, the taxpayer may be able to breathe new life into what was thought to be a lost cause.
    Can you do a 1031 exchange after closing?
    The use of rescission has long been recognized in law generally in connection with transactions not related to 1031 exchanges. However, the Internal Revenue Service (“IRS”) has allowed the use of rescission to correct a problem with an exchange transaction. “Rescission” is not defined in the Internal Revenue Code or the Treasury Regulations, which are the source of most rules used to advise taxpayers. Rather, rescission is a concept which some courts have allowed, and the IRS has blessed, specifically in Penn v. Robertson, 115 F2d 167, 40-2 U.S. Tax Cas. (CCH) P. 9707 (CCA 4th Cir. 1940).
    As an example, consider an individual taxpayer closes the sale of a parcel of land in February 2020 for a sizable gain. The taxpayer receives the sale proceeds but later finds out they could have deferred substantial tax liability by doing a 1031 exchange. As long as the taxpayer makes the decision to rescind the transaction in the same tax-reporting period–in this example before 2020 year-end–the taxpayer can contact the buyer and they can agree to rescind the transaction. Of course, should the buyer not be willing to cooperate, or should there be a buyer’s lender who does not wish to participate, this process may not be feasible.
    Seller and buyer agree to rescind. What happens next?
    When a rescission is properly completed, the IRS treats the sale as if it never happened, as long as the taxpayer receives the property back from the buyer and the buyer receives the full purchase price back from the taxpayer on or before the end of the tax reporting period for the taxpayer. The parties may agree they were laboring under mutual mistake of fact or some other reason for the decision to rescind. Another important consideration is when the rescission of the transaction is complete, the parties should have no further obligations to each other to take any further action. If these criteria are met, pursuant to the authorities cited above, the parties are in the exact position they were prior to the sale. The taxpayer and the buyer can then undertake another sale and purchase transaction and close the transaction with the participation of a QI company, like Accruit, receiving the exchange proceeds so it can help process the taxpayer’s 1031 exchange. In order to ease the burden on the buyer during rescission, it may be helpful if the taxpayer agrees to pay for any buyer expenses incurred in accommodating the taxpayer.
    Typically, the QI company is not in a position to provide legal advice regarding the rescission process or provide any rescission agreement. There are numerous attorneys and CPA’s nationwide who are knowledgeable in this area of the law and who can help advise the taxpayer.
    Do you have an uncommon situation that you have questions about? https://www.accruit.com/contact-us”>Ask our experts. 
     

  • Selecting the Entity for a Real Estate Purchase – Limited Liability Companies

    What is a Limited Liability Company?
    Limited liability companies (LLCs) are the most popular choice of organizational form because of the inherent flexibility in most state statutes that enhances the ability of the entity to adopt features that best serve its objectives. LLCs are a very common choice for owning real estate because of their tax treatment, limited liability and flexibility in allocating power structure and management responsibilities.
    The best way to understand the unique features of an LLC is to distinguish it from the other entities we’ve discussed in Parts I – III in this blog series. The principal purpose of the LLC is to obtain favorable tax benefits along with the limitation of liability.
    Advantages and Disadvantages of an LLC
    Real estate investors are well served by forming the LLC in a state that has favorable limited liability company act statutes, like Delaware (or Illinois after recent amendments to its Limited Liability Company Act). The goal is to pay no federal income tax at the entity level. An LLC provides an unlimited number of investors with the limited liability of a corporation but the tax advantages of a partnership.
    On the other hand, significant disadvantages exist by using the corporate form for real estate investment. The individual shareholders cannot obtain any of the tax benefits generated by the investment. Unlike a partnership, no pass-through of the corporation’s income tax deductions exists. Corporation profits are also taxed twice – once at the corporate level though the payment of the corporate income tax and again at the shareholder level with the shareholder’s payment of individual income taxes on the distributions received from the corporation. An LLC allows the losses and gains to flow through to the investors.
    Subchapter S-corporations allow investors to avoid the double taxation of the corporation’s profit and the inability of the corporation to pass its income tax losses and credits on to the shareholders while still providing them with limited liability. Nevertheless, an S-corp cannot have different power allocations among the shareholders. In other words, an S-corp is a corporation that will not allow the investors to establish an unbalanced management structure. The investors can decide who will be active in decision making, operating the property and spending time on a regular, continuous, and substantial basis.
    How to Form and Operate an LLC
    Two documents are needed to form and operate an LLC: Articles of Organization and an Operating Agreement.
    An LLC is formed by filing Articles of Organization with the applicable Secretary of State and paying any applicable fees. The Articles of Organization must comply with the enabling legislation enacted in the state under whose laws the LLC is formed. Many states allow the filing to be done electronically, others require sending the paperwork in to the Secretary of State.
    The Operating Agreement provides for the operation of the LLC. It is the controlling document that governs the relationship between the members, managers, and the obligations of each.
    The Operating Agreement can spell out power allocations and management responsibilities of the members and managers as well as an exit strategy. There is no need for a board of directors or elections because the members just file forms and pay fees to the Secretary of State. The LLC also creates and maintains contractual flexibility. All of the members have the authority to make management decisions unless a different power structure is adopted.
    An LLC can be manager- or member-managed. The managers or managing-members who make management decisions on behalf of an LLC generally have limited liability protection. They are not personally liable for the debts and liabilities of an LLC unless a basis to pierce the limited liability shield exists as may be required by public convenience, fairness, or necessity. An LLC will insulate a member’s personal assets from claims of outsiders and other members.
    In many instances, an LLC provides investors with the best entity for their individual and collective needs. Unlike a C-corporation, there is no need for a board of directors, meetings, or elections because the members just file forms and pay fees. An LLC is free from qualification restraints imposed on a S-corp.
    How to Dissolve an LLC
    LLC organizers can provide for the LLC’s dissolution on a fixed date in the filed Articles of Organization or continuation in existence until dissolved by the consent of the members or on the occurrence of an event specified in the Operating Agreement. Insofar as the payment of claims, members can arrange for the liquidation of an LLC’s assets to pay current claims, fund reserves for the payment of contingent claims, and determine the proportion of the remaining assets distributable to each member based on the member’s capital account or other measure specified in the Operating Agreement. When the members are ready to wind down and terminate, an LLC can proceed to file Articles of Termination with the applicable Secretary of State after claims have been paid and all remaining assets have been distributed to members, file a Certificate of Cancellation canceling the LLC’s Certificate of Authority to transact business in states other than the state of its organization (if any), and arrange for the filing of a final income tax return for the LLC.
    Summary
    The LLC generally provides real estate investors with a superlative choice for their individual and collective needs. Nevertheless, individuals should consider the following factors in their entirety when selecting the business entity for purposes of owning real property:

    How long the investors wish to keep the property
    Nature of the relationships between them
    Personal liability
    Tax treatment
    Management structure
    Number of investors
    Duration of the entity
    Exit strategy
    Allocations of power within the entity
    Any other special provisions

     
     

  • Selecting the Entity for a Real Estate Purchase – Limited Liability Companies

    What is a Limited Liability Company?
    Limited liability companies (LLCs) are the most popular choice of organizational form because of the inherent flexibility in most state statutes that enhances the ability of the entity to adopt features that best serve its objectives. LLCs are a very common choice for owning real estate because of their tax treatment, limited liability and flexibility in allocating power structure and management responsibilities.
    The best way to understand the unique features of an LLC is to distinguish it from the other entities we’ve discussed in Parts I – III in this blog series. The principal purpose of the LLC is to obtain favorable tax benefits along with the limitation of liability.
    Advantages and Disadvantages of an LLC
    Real estate investors are well served by forming the LLC in a state that has favorable limited liability company act statutes, like Delaware (or Illinois after recent amendments to its Limited Liability Company Act). The goal is to pay no federal income tax at the entity level. An LLC provides an unlimited number of investors with the limited liability of a corporation but the tax advantages of a partnership.
    On the other hand, significant disadvantages exist by using the corporate form for real estate investment. The individual shareholders cannot obtain any of the tax benefits generated by the investment. Unlike a partnership, no pass-through of the corporation’s income tax deductions exists. Corporation profits are also taxed twice – once at the corporate level though the payment of the corporate income tax and again at the shareholder level with the shareholder’s payment of individual income taxes on the distributions received from the corporation. An LLC allows the losses and gains to flow through to the investors.
    Subchapter S-corporations allow investors to avoid the double taxation of the corporation’s profit and the inability of the corporation to pass its income tax losses and credits on to the shareholders while still providing them with limited liability. Nevertheless, an S-corp cannot have different power allocations among the shareholders. In other words, an S-corp is a corporation that will not allow the investors to establish an unbalanced management structure. The investors can decide who will be active in decision making, operating the property and spending time on a regular, continuous, and substantial basis.
    How to Form and Operate an LLC
    Two documents are needed to form and operate an LLC: Articles of Organization and an Operating Agreement.
    An LLC is formed by filing Articles of Organization with the applicable Secretary of State and paying any applicable fees. The Articles of Organization must comply with the enabling legislation enacted in the state under whose laws the LLC is formed. Many states allow the filing to be done electronically, others require sending the paperwork in to the Secretary of State.
    The Operating Agreement provides for the operation of the LLC. It is the controlling document that governs the relationship between the members, managers, and the obligations of each.
    The Operating Agreement can spell out power allocations and management responsibilities of the members and managers as well as an exit strategy. There is no need for a board of directors or elections because the members just file forms and pay fees to the Secretary of State. The LLC also creates and maintains contractual flexibility. All of the members have the authority to make management decisions unless a different power structure is adopted.
    An LLC can be manager- or member-managed. The managers or managing-members who make management decisions on behalf of an LLC generally have limited liability protection. They are not personally liable for the debts and liabilities of an LLC unless a basis to pierce the limited liability shield exists as may be required by public convenience, fairness, or necessity. An LLC will insulate a member’s personal assets from claims of outsiders and other members.
    In many instances, an LLC provides investors with the best entity for their individual and collective needs. Unlike a C-corporation, there is no need for a board of directors, meetings, or elections because the members just file forms and pay fees. An LLC is free from qualification restraints imposed on a S-corp.
    How to Dissolve an LLC
    LLC organizers can provide for the LLC’s dissolution on a fixed date in the filed Articles of Organization or continuation in existence until dissolved by the consent of the members or on the occurrence of an event specified in the Operating Agreement. Insofar as the payment of claims, members can arrange for the liquidation of an LLC’s assets to pay current claims, fund reserves for the payment of contingent claims, and determine the proportion of the remaining assets distributable to each member based on the member’s capital account or other measure specified in the Operating Agreement. When the members are ready to wind down and terminate, an LLC can proceed to file Articles of Termination with the applicable Secretary of State after claims have been paid and all remaining assets have been distributed to members, file a Certificate of Cancellation canceling the LLC’s Certificate of Authority to transact business in states other than the state of its organization (if any), and arrange for the filing of a final income tax return for the LLC.
    Summary
    The LLC generally provides real estate investors with a superlative choice for their individual and collective needs. Nevertheless, individuals should consider the following factors in their entirety when selecting the business entity for purposes of owning real property:

    How long the investors wish to keep the property
    Nature of the relationships between them
    Personal liability
    Tax treatment
    Management structure
    Number of investors
    Duration of the entity
    Exit strategy
    Allocations of power within the entity
    Any other special provisions

     
     

  • Selecting the Entity for a Real Estate Purchase – Limited Liability Companies

    What is a Limited Liability Company?
    Limited liability companies (LLCs) are the most popular choice of organizational form because of the inherent flexibility in most state statutes that enhances the ability of the entity to adopt features that best serve its objectives. LLCs are a very common choice for owning real estate because of their tax treatment, limited liability and flexibility in allocating power structure and management responsibilities.
    The best way to understand the unique features of an LLC is to distinguish it from the other entities we’ve discussed in Parts I – III in this blog series. The principal purpose of the LLC is to obtain favorable tax benefits along with the limitation of liability.
    Advantages and Disadvantages of an LLC
    Real estate investors are well served by forming the LLC in a state that has favorable limited liability company act statutes, like Delaware (or Illinois after recent amendments to its Limited Liability Company Act). The goal is to pay no federal income tax at the entity level. An LLC provides an unlimited number of investors with the limited liability of a corporation but the tax advantages of a partnership.
    On the other hand, significant disadvantages exist by using the corporate form for real estate investment. The individual shareholders cannot obtain any of the tax benefits generated by the investment. Unlike a partnership, no pass-through of the corporation’s income tax deductions exists. Corporation profits are also taxed twice – once at the corporate level though the payment of the corporate income tax and again at the shareholder level with the shareholder’s payment of individual income taxes on the distributions received from the corporation. An LLC allows the losses and gains to flow through to the investors.
    Subchapter S-corporations allow investors to avoid the double taxation of the corporation’s profit and the inability of the corporation to pass its income tax losses and credits on to the shareholders while still providing them with limited liability. Nevertheless, an S-corp cannot have different power allocations among the shareholders. In other words, an S-corp is a corporation that will not allow the investors to establish an unbalanced management structure. The investors can decide who will be active in decision making, operating the property and spending time on a regular, continuous, and substantial basis.
    How to Form and Operate an LLC
    Two documents are needed to form and operate an LLC: Articles of Organization and an Operating Agreement.
    An LLC is formed by filing Articles of Organization with the applicable Secretary of State and paying any applicable fees. The Articles of Organization must comply with the enabling legislation enacted in the state under whose laws the LLC is formed. Many states allow the filing to be done electronically, others require sending the paperwork in to the Secretary of State.
    The Operating Agreement provides for the operation of the LLC. It is the controlling document that governs the relationship between the members, managers, and the obligations of each.
    The Operating Agreement can spell out power allocations and management responsibilities of the members and managers as well as an exit strategy. There is no need for a board of directors or elections because the members just file forms and pay fees to the Secretary of State. The LLC also creates and maintains contractual flexibility. All of the members have the authority to make management decisions unless a different power structure is adopted.
    An LLC can be manager- or member-managed. The managers or managing-members who make management decisions on behalf of an LLC generally have limited liability protection. They are not personally liable for the debts and liabilities of an LLC unless a basis to pierce the limited liability shield exists as may be required by public convenience, fairness, or necessity. An LLC will insulate a member’s personal assets from claims of outsiders and other members.
    In many instances, an LLC provides investors with the best entity for their individual and collective needs. Unlike a C-corporation, there is no need for a board of directors, meetings, or elections because the members just file forms and pay fees. An LLC is free from qualification restraints imposed on a S-corp.
    How to Dissolve an LLC
    LLC organizers can provide for the LLC’s dissolution on a fixed date in the filed Articles of Organization or continuation in existence until dissolved by the consent of the members or on the occurrence of an event specified in the Operating Agreement. Insofar as the payment of claims, members can arrange for the liquidation of an LLC’s assets to pay current claims, fund reserves for the payment of contingent claims, and determine the proportion of the remaining assets distributable to each member based on the member’s capital account or other measure specified in the Operating Agreement. When the members are ready to wind down and terminate, an LLC can proceed to file Articles of Termination with the applicable Secretary of State after claims have been paid and all remaining assets have been distributed to members, file a Certificate of Cancellation canceling the LLC’s Certificate of Authority to transact business in states other than the state of its organization (if any), and arrange for the filing of a final income tax return for the LLC.
    Summary
    The LLC generally provides real estate investors with a superlative choice for their individual and collective needs. Nevertheless, individuals should consider the following factors in their entirety when selecting the business entity for purposes of owning real property:

    How long the investors wish to keep the property
    Nature of the relationships between them
    Personal liability
    Tax treatment
    Management structure
    Number of investors
    Duration of the entity
    Exit strategy
    Allocations of power within the entity
    Any other special provisions

     
     

  • Selecting the Entity for a Real Estate Purchase – Corporations

    C-Corporations
    Corporations are one of the oldest forms of legal entities.  A significant body of case law and statutes exist defining the rights and liabilities of shareholders, officers, directors, and third parties dealing with the corporate entity.  Certain states, like Delaware, have particularly favorable business corporation statues.  As a result, many firms will strategically organize in those states in order to obtain the benefit of those advantageous laws.  
    Unlike a general partnership that can come into existence without filing anything affirmative, a corporation has a separate legal existence.  The corporate structure serves to insulate most of the debts from the shareholders.  A corporation is able to hold property in its own name and provide its shareholders with limited liability so long as the shareholders do not commingle funds or engage in other prohibited, self-serving activities.  
    By-laws are controlling documents enacted by the incorporator who organizes the entity.  The by-laws govern the actions of the corporation and relationships of the shareholders, directors, officers and third-parties dealing with the entity.  They set forth the framework within which the corporation must operate regarding important aspects, such as management, distributions and dissolution.  The board of directors and officers of the corporation provide the management.  
    Some advantages of c-corporations are:

    a perpetual life
    no restrictions with regard to the participation in management
    the permissibility of any power structure  

    One particularly important benefit of utilizing the corporate form of ownership is the limitation of liability for officers and directors of the corporation.  Unlike a limited partnership, the corporation’s shield of limited liability is not lost by the shareholder’s participating in the management of the corporation or its property.  
    Nevertheless, officers of corporations that own real estate must be aware of the potential for personal liability in certain circumstances.  A court may decide to “pierce the corporate veil” whenever required by public convenience, fairness, or necessity.  
    For example, the corporate form may be disregarded by a court when there is such a unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist.  In other words, the corporation must strictly observe the formalities associated with this form of ownership or else risk having personal liability.  
    Another example where personal liability could potentially be imposed in a real estate ownership context is for environmental hazards under statutes like the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), known also as “Superfund.” 
    Significant disadvantages exist when using the corporate form for real estate investment.  First and foremost, the individual shareholders cannot obtain any of the tax benefits generated by the investment.  Unlike a partnership, no pass-through of the corporation’s income tax deductions exists.  The corporation’s profits are taxed twice at the corporate level through the payment of the corporate income tax and at the shareholder level by the shareholder’s payment of individual income taxes on the distributions they receive from the corporation.  States also impose corporate income and franchise taxes which can materially and adversely affect the financial considerations of owning real estate in a corporation.        
    S-Corporations
    Subchapter-S corporations are c-corporations that have filed an election with the IRS using Form 2553.  S-corps allow investors to avoid the double taxation of the corporation’s profit and the inability of the corporation to pass its income tax losses and credits onto the shareholders while still providing them with limited liability.  
    Nevertheless, certain limitations apply to Subchapter-S corporations such as:  

    There can be no more than one class of stock.
    There can be no more than 75 stockholders.
    Essentially all investors must be individuals.

    Profits and losses pass through to the shareholders without a corporate income tax.  Shareholders of S-corps are taxed the same as partners, and the taxable income is treated as partnership income.  
    A disadvantage of S-corps is the difficulty in transferring real estate and other property held by the corporation caused by the limitation on the number of investors.  Also, S-corps are subject to the IRS passive loss rules.  Lastly, an additional problem imposed by Subchapter-S occurs in the event of liquidation of the corporation or the conveyance of its assets to an operating entity.  The corporation could be required to pay corporate level capital gains tax.  
    In part four of our continuing series of blogs, we will discuss limited liability companies as a form of real estate ownership.