1031 exchange, LLC and buying out partners?

Question

So curious if anyone else has experienced this and how the dealt with it.

Myself and 2 friends created an LLC to pool our $$ to invest in an apartment complex. The General Partners of the larger investment are closing on the planned sale of the property after holding/fixing it up for the last 3 years. This is all great news and we're making a lot of money (24.73%IRR, MOIC 1.67x, 67% total return, 23% annual return) and now are looking at what to do w/ this 1031 exchange. We have found a new offering to roll this into, as an LLC, but one of the members may want to cash out.

One of my LLC members is getting divorced. His name is on the LLC. He wants to either cash himself out completely or transfer his ownership to his wife and walk away. Any advice on how to do this? At the end of the day, the LLC needs to either cash out or 1031, right? so internally, the 2 remaining partners could put forward more $$ to cover the 3rd person who wants out?

Adam L. · Answer

Good point! I need to think about it more like this. Previously, I've been 'thankful' to the big company and tip toeing around, like I don't want to lose my $155k spot in their offering. How to walk to line on this? The BigLLC came back with this solution after I told him I fear we will need to ask for distribution and not 1031 the $$.

Dave Foster · Answer

@Adam L., Yah, I don't see a 1031 opportunity here as is other than Big LLC doing the exchange.  Friendly LLC does not own any real estate so it has nothing to 1031.

Yes the drop and swap method could work.  Big LLC dissolves and distributes the interests of the LLC to the individual members as tenants in common and then each goes it's own way.  Friendly LLC is the investor.  so I'm guessing they will only quit claim to their investors (Friendly LLC).  An interesting question would be can Friendly LLC also dissolve and drop in time to make that work.  I doubt it.

But if Friendly LLC ends up owning a TIC interest, it could do a 1031 exchange and buy three different properties (one for each of the three members).  Then once the 1031 is complete Friendly LLC could also dissolve and distribute the properties to each member.  This is the reverse of the drop and swap (sort of a swap and drop if you will).

But that being said, if Friendly LLC did own real estate then you're absolutely right you would have to use the services of a qualified intermediary (someone like us) to document the 1031 exchange and holds the proceeds in between sale and purchase.

Adam L. · Answer

@Dave Foster

I have some more questions about cashing out the third partner. Here's the real numbers so we can talk about them.

$25k original investment per person grew to $39k in 3 years. The wife is kinda sorta interested in taking his share, but probably  not. Looks like at the end of the day, the third buddy needs to be cashed out and removed completely.

So how do we go about buying out or cashing out the 3rd partner? A friend of mine was saying to just write him a check out of the biz account for the full $39k, declaring it as returning his $25k priniciple plus $14k gains. Then he deals with the taxes on his own SSN. However, some other ppl here have said to pay the partner less a withholding for future taxes.

Then also, how to go about doing the cash out? We don't have that $$ on hand (its in the investment), so do I need to ask for $39k distribution from the larger investment LLC to pay him, then I backfill by writing a check to the biz account for the $39k?

Do I write a check into the account in advance, keeping the original investment in tact, then write the partner his $39k check?

Adam L. · Answer

Thank you for the input. Here's some more details I received from the main LLC that owns the investment property:

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I want to first assure you that the responsibility to execute the 1031 correctly is ours at [ParentLLC], and something we’re both experienced with and utilize several very talented outside legal and tax advisors to successfully execute. From the Limited Partner (LP) perspective, you will not realize the difference or have any unusual tax work on your side required. We do all of that for you and you’ll get a K1 form for taxes like before.

The {ParentLLC] entity is going to become a TIC ownership entity with title. You as an LP are shielded and not listed on any public documents or individually listed on anything. If an investor doesn’t participate in the exchange, we pay them out and it won’t impact the ability for other investors (will be the majority, if not all investors) to successfully participate in the exchange. We did this same process in June 2019 when we sold our first property.

I hope you are not overthinking the situation here. It is seamless/simple/painless and totally passive for you.

Your LLC on its own, where you’re a non-title holding Limited Partner within a larger LLC entity, cannot effectuate it’s own 1031 exchange. The 2 real options are to pay long-term capital gains on any tax liability you have from this sale and get paid out, or to participate in our 1031 exchange. Two good options though fortunately!-------------------------------------------------------------

So we/[my small LLC] needs to decide to reinvest into the parent LLC or cash out. The question about divorce and internal assignments will be totally separate.

Dave Foster · Answer

@Adam L., The LLC is the taxpayer for that current property. So it would need to be the seller and buyer in your 1031 exchange.  But that is the entity itself that matters for the 1031. It doesn't matter who the members of the entity are.  So you actually have a few options.

1. You could buy his interest out in the LLC so the two members share 100% of the ownership.  It would still be the LLC selling and doing the 1031.  This would require cash to buy him out - or a note from the LLC and the two members.

2. He could assign his membership interest to his wife and you would still be the LLC just with different members (can't even begin to imagine all the potential bad potentials in that)

3. You could have the LLC sell and do a partial exchange where it buys the replacement property but keeps some cash to give to the former member in exchange for their interest.  You would need to make their buyout net of any tax liability for the boot from the 1031.

4. You could also dissolve the LLC and distribute the asset to the former members as tenants in common.  the the property would sell and two of you would continue in a 1031 to buy your new target.  And he could take his share, pay the tax, and the divorce attorney.

Jesse Daconta · Answer

This sounds like a question for @Dave Foster

Paris Snow · Answer

Hi

Im in exactly the same situation but just little different. can i have an advise from you both?

Thank you

Dave Foster · Answer

@Adam L., That's starting to look like a very good solution.  Big LLC is being very accommodating (as they should since you're leaving your money in for them to use to acquire their next project.

Adam L. · Answer

@Dave Foster**update**

So I've talked with the BigLLC a bit and brainstormed this solution. If we move forward with the 1031 event as a FriendLLC, the BigLLC can then split up our interests a few months down the road after they close on the new property and everything is in a steady state. Seems like a win/win/win right?

From the CEO of the BigLLC

[quote]I’m going to share the direct feedback we’ve received below from the CFO and CPA's. If the 3 partners in your LLC can ensure that you’ll follow this pathway, we can all collectively make this happen and execute on the breakup of your LLC after the 1031 exchange is completed and settled – so several months from now. And, it means we will not be redeeming your 3rd partner. He has to agree to participate as I’m sure everyone can appreciate here.

This should not be an issue if they roll into the 1031 and then break up their interests into 3 direct interest.  Basically their partnership/LLC would be distributing up the interests in [new property] to the individual investors after we close. I prefer they do this after [new property] closes and we complete the 1031 exchange as the 1031 is messy enough as is. Should be straight forward after if they do at any time as long as we are not redeeming anyone out and their individual interests remain the same.[/quote]

Adam L. · Answer

@Dave Foster

So i'm reading more about 1031's and it seems clear that the seller cannot touch the money at all otherwise it voids eligibility.

So the FriendLLC cannot receive the $155k and the individual members cannot get their share distributed because then we would void the 1031 terms.

so I need to find an escrow service or something to recieve and hold and then reinvest ? Any advice?

1031 exchange, LLC and buying out partners?

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