Is Your Building Ownership a Mirror Image?

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Commercial real estate ownership is a beautiful thing! What other investment can you own and experience the tax advantages of depreciation, passive income treatment, and capital gains - all while the asset is appreciating.

If you own a business that occupies your commercial real estate - even better! Now, you have the occupant (tenant) paying you (landlord) rent. I’ve witnessed this structure numerous times over the years - and it works the majority of the time.

Today’s column is centered around those few occasions when the structure hits a snag.

First a bit of background:

Common among commercial real estate ownership is an entity known as an LLC - Limited Liability Company. An LLC may have one or a number of “members” each with a percentage of the stake. The LLC owns and operates the real estate - collects rent, pays the bills, is registered with the state, and files a tax return. Generally the taxes owed are passed down to the members via a K-1. Great!

Common among operating business ownership is the corporation - generally a C or S Corp. Each have different rules of taxation - which is a topic for another day. Suffice to say this entity pays rent to the building ownership - LLC. Cool!

Here’s where things can get dicey.

The LLC and Corporation have different owners. More than once recently we’ve seen this. What starts as an LLC with members whose ownership percentages mirror the shares of the business corporation can morph over time. In one extreme example - we had a building ownership comprised of a church, an ex-wife, two of the original owner’s children, a non-profit, and a former health care taker. By the way - initially the LLC had one member - the proprietor of the company! Death of the original owner caused all manner of chaos - as you can imagine. The result? An eviction of the business and a forced sale of the real estate. Ugly!

The operating business changes hands. With the spate of merger and acquisition activity these days - this is quite common. Typically, the company is acquired, a lease is struck with the LLC and things proceed. Over time however, a disconnect can occur - a smaller footprint is needed, sales decline, expensive improvements are required, the business goes bust. All easy when the building and business are identical twins. Not so easy when the twins are fraternal.

The commercial real estate is sold. No problem if you’re happy to fork over close to half the gain the commercial real estate has enjoyed. Sell it and pay Uncle Sam and Cousin Gavin. Done! If, however, the LLC chooses to defer the gain through the use of a 1031 tax deferred exchange - the LLC - all of the members - must be in lock step. What if an LLC member wants to take his cash and move to Cabo? A complicated buyout must follow. We’ve witnessed what’s called a “swap and drop” in these instances. Simply, the LLC is disbanded and replaced with a Tenants in Common vesting. Now the “tenants” - upon the sale - can self direct their percentage of the sale proceeds. In practice, this is much more complex. Please seek tax and legal counsel before employing this strategy!

Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.com.