Equity transferred between LLCs of different ownership-Taxed?

Question

This is hypothetical:
I have joined a partnership with one other individual to purchase a multi-unit building.  For simplicity of argument, I have performed 100% of the maintenance and improvement of the property. My partner has performed 0%, and we both agree to that work distribution. After improvement, the property is now worth $100k more.  Could I borrow against the new value of the building to obtain cash, and then use that cash to buy a building for myself? This would be using the equity from the partnership LLC to buy a property for my personal LLC.  Though I would not think the interest on the $100k loan would be deductible to the partnership(not for the business use), would there be any tax to be paid for this transfer between LLCs?  Is this to filed under IRS M-1?

It seems to me that some sort of tax would have to be paid, otherwise this would appear to be $100k in income personally. However, this is borrowed money which isn't really income.  You don't pay taxes when you take out a mortgage (% of the mortgage).

Ethan Cole · Answer

Thank you Chris and Ebere,

Ebere, 
I am not all that knowledgeable with LLCs.  Is taking out a distribution equivalent to a percentage change in ownership, as though my 50% stake in a building would become 25%(or however much agreed upon)?  And therefore I should receive 25% of the profits of the partnership rather than 50%?

Also, though you did not directly state it, a guaranteed payment would be taxable. Is that correct?

Ethan Cole · Answer

Thought about my last post last night, and you would not want one entity to own the other.  It would be at risk for transferring liability.

Ethan Cole · Answer

Say the original building was under my own personal entity and I wanted to borrow against the improved value-

I borrow the cash for liquidity and then purchase the 2nd building afterwards.  The 2nd building has its own separate entity.

Would the 1st entity own the 2nd to account for the transfer in cash?  Therefore the 2nd is an asset of 1st and could have deductible items like the original loan interest.  Otherwise it seems to me that it would not be a business related transfer.

This would not work with my partnership scenario because my partner would therefore own half of my "income" entity. But I am curious as to how this would work were I to be doing this on my own.

Ebere Okoye · Answer

There are two different issues here.  1)  Converting Equity to debt is not a taxable transaction for the first LLC.    2)  Taking a distribution out of an LLC to contribute into another LLC is not a taxable transaction.

There are 2 ways to take money out of an LLC - as a distribution or as guaranteed payments. Unless you all agree that the debt created will be used to pay you a guaranteed payment, the money taken out is considered a distribution and therefore not taxable.

I hope this helps.

Chris Martin · Answer

The way I see it... Borrowing against a property doesn't change the basis and isn't a sale. The scenario you describe doesn't create a taxable event. If you can "borrow against the new value of the building to obtain cash, and then use that cash to buy a building for myself..." that depends on your partnership agreement or multi-member LLC operating agreement.