STR under LLC- how to pay the least amount of taxes?

20 Replies

Hello BP family!

My friends and are thinking of investing in a STR in Palm Springs, bought under an LLC. Our biggest question is how to structure the exit strategy in the operating agreement, and the best way to distribute profits to minimize taxes paid, and maximize profit that we gain individually to use to invest in other properties (not under the LLC). We have been doing research on a 1031 exchange, which seems like a great option to defer taxes temporarily, but from what we understand, eventually that may need to come to an end when we eventually sell the property, and pay taxes on the capital gains. Here's the scenarios as I understand:

Option 1: Distribute profits (annually, for instance) via the LLC, and depreciate the value of the house so that we are paying minimal income taxes every year. Keep the house until it is depreciated to $0, and then use a 1031 exchange to buy a Like-Kind property. Then sell the house and pay taxes on the newer purchase.

Option 2: Distribute profits via the LLC, and depreciate the value of the house so that we are paying minimal income taxes every year. Then pay taxes on on the appraised cost of the home when we sell.

Option 3: Distribute profits via the LLC and pay income taxes on the profits, without depreciating the value of the house. Then pay taxes on any appreciation on the house when we sell it. (This is how, I think, most non-strategic tax accountants would do it).

This question may be moot, because it depends on each individual's end goal, but was curious anyone's initial thoughts, pros/cons, or insight into other options we may be missing. Thanks in advance!

@Jessica,

You can keep doing a 1031 and never pay taxes on the gains. Then your heirs would get the final 1031 property/s at the stepped up basis avoiding ever paying capital gains.

You can depreciate the house every year but if you sell one day you will have to pay taxes on the sale price not the appraised value.

@John Underwood That part I do understand. But in the case of our multi-member partnership, waiting to die wasn't an option. We know we just have to pay the taxes, the question is more what scenario means we pay the least amount of taxes.

@Jessica Chow I am not trying to be a jerk with my answer. You don't have to wait to die to not pay tax. You can not pay it right now and every time you do another 1031. If you do this, you don't have to ever think about paying tax on this. The least amount of tax you can pay is zero and it is attainable. If you want to sell and not do a 1031 and pay tax then that might be what is best in order to cash out multi-members in your partnership.

BTW, taking depreciation is not a choice......when you sell you get taxed on the depreciation recapture whether or not you ever took the depreciation.
Concentrate on making the profits first, it’s not automatic, then decide how to minimize the taxes.

@Jessica Chow , your exit strategy and operating strategy are totally different critters and it's a little difficult to tell what you're going for.  But here's some guidance for  you to take to your planning professionals.

First forget the 1031 exchange as an operating strategy.  It is only available upon sale of your property. And yes it is temporary (or indefinite as some would say).  But as long as you are willing to re-invest in new real estate you will be allowed to use the deferred tax to grow your portfolio - right up until death when heirs will get the property at a stepped up basis as @John Underwood alluded to.  Because depreciation is also deferred by the 1031 exchange it will come into play as well.

Option 1 doesn't do anything for you.  Doing a 1031 and then later selling the new property does not give you a break on the taxes.  

Option 2 if fine if you want to pay tax on the gain from your sale.  But you will not pay on any appraised cost.  You will pay tax on the recognized gain which if you follow option 2 will be the difference between the adjusted cost basis of the last property and it's net sales price.  And the adjusted cost basis is determined during the 1031 exchange.   

Option 3 also doesn't do anything for you.  You will be taxed on all depreciation you took or could have taken when you sell so there is no motivation to not take the depreciation allowance as you go.  You're going to pay the tax on it anyway.

Bottom line - If you sell a piece of real estate you pay tax unless you do a 1031 exchange.  

@John Underwood - Makes sense, thanks!

@Dave Foster - Very helpful, thank you for breaking it out like that. So net-net, it sounds like there's no "best way," since you'll end up paying taxes either way. Then the question becomes- would I prefer to pay income taxes or real estate taxes on the sale?

@Jessica Chow There are couple other options.

Option 4: Look into monetized installment sale. Using this, you won't get a big tax hit as you will get money annually. If you need help with this, ping me and I can introduce you to my tax advisor.

Option 5: Use oil and gas or conservation easements to write off most of the gains when you sale the property. 

Disclaimer: I am not a CPA or tax advisor. I learned some of these by attending courses and bootcamps by Tom Wheelwright and Mark Kohler.

Not quite @Jessica Chow , There will be income taxes from operation.  Your business structure will determine what those are, where they are offset, etc.  Get a good accountant to help you structure.

Then there is gain/profit from the sale of assets.  These can mitigated partially or entirely with a 1031 exchange.  For that you use a Qualified Intermediary. 

@Alpesh Parmar I looked into monetized installment sale, and this would only be possible under a 30-year loan, or a 30-year deal? Does it work after 5? We're not looking to be in business or keep the property for 30 years. Just 3-5 years.

Thanks for your Option 5! Definitely going to ask my accountant about that.

@Dave Foster - Thanks for that clarification (I think I'm tracking). Do you think it's better to minimum the income tax then, and just pay taxes after the sale of the property? Or do you think it doesn't matter?

We are definitely hiring an accountant and a lawyer to help us structure the partnership. Definitely needed in this case, especially if we look into more complex scenarios, like the monetized installment sale.

Originally posted by @Jessica Chow :

@Alpesh Parmar I looked into monetized installment sale, and this would only be possible under a 30-year loan, or a 30-year deal? Does it work after 5? We're not looking to be in business or keep the property for 30 years. Just 3-5 years.

Thanks for your Option 5! Definitely going to ask my accountant about that.

 I agree that it would work with 30-year deal. You can also make your own MIS by owner financing the property during the sale. I haven't done any of these strategies but I have educated myself to a point where I can be dangerous. :)

@Dave Foster Don’t names on both deeds need to be the same for 1031exchange, as in same name to same name and not name to llc?

While we’re on the subject, can you sell a property and 1031 into a syndicated deal? 

@Nancy Bachety , If the LLC is a regarded entity that is true. However there are ways to still use the 1031 with a regarded LLC to position it's holdings to be what the members want. And then after the 1031 to dissolve the LLC and distribute the new properties to the individual members.

Generally it does not work to try to 1031 into a syndication. The vast majority of the time the syndication is an LP or LLC and it is dependent on financing so the lender will not allow the 1031 investor to purchase part of the property initially as a TIC. There are a few syndicators out there who advertise that their syndications are 1031 compatible. And it is possible but not likely. Every deal should be examined closely and before it's too late to change course.

A TIC structure could be called a syndication. And that is perfectly fine to 1031 into. A syndication in it's purest form is just a group of people banding together in a structure to own an asset. It is the structure that makes it compliant or not.

@Jessica Chow While off the topic at hand, why Palm Springs?  The regulations in PS proper are super restrictive, and require a ton of oversight and a leap of faith that the neighbors won't call in bogus complaints.  There are many surrounding cities where one can sleep easier at night.....

I think people get very caught up in minutia that doesn’t need to occur. If it’s 3 people looking to buy a piece of real estate and it’s only one property then all the gyrations with an LLC and possible 1031 is a waste of time. If you are purchasing with a bank mortgage someone personally will need to sign for the loan, unless you have a long standing bank relationship and have done this before. If it’s a private lender there will obviously be more flexibility.

I would spend time with someone who has actually performed several of these transactions and have them mentor you. It seems like you have done some research, which is great, but I never met a book at the closing. Book info vs real life is very different. Good luck and I wish you the best!

Originally posted by @Jessica Chow :

@Alpesh Parmar I looked into monetized installment sale, and this would only be possible under a 30-year loan, or a 30-year deal? Does it work after 5? We're not looking to be in business or keep the property for 30 years. Just 3-5 years.

Thanks for your Option 5! Definitely going to ask my accountant about that.

 In a monetized installment sale you get cash up front, hence "monetized" installment sale. The intermediary installment sale is what gives you the tax deferral. Your taxes are deferred until you receive the balloon payment at the end of the contract term.

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There are multiple variables you're considering here that should be looked at independently. 

Short answer: Your LLC is a pass through entity and distributions won't impact your taxable income. Distributions only impact your capital balance an whether or not your LLC is structured in a way that your allocation of income/expenses is dictated by the capital balance you maintain in your LLC. Therefore, when it comes to minimizing taxable income it's really dependent on how much rental income you bring in, offset by depreciation and deductible operating expenses.

As @John Underwood mentions you can hold the property and never pay taxes on appreciation if you execute 1031's until it's passed on through inheritance with your benefactors getting the tax basis at FMV, but based on the fact that you're looking to acquire this property with friends that's most likely not the strategy. The question around the 1031 would be if the 1031 would be executed by the LLC. I'm not sure how the 1031 works for capital gains deferal when you have ownership of a property within an LLC and then take those capital gains and potentially 1031 by purchasing another property as an individual or different entity.

The distribution amount only factors in when deciding how much cash you want to keep in the LLC to cover future maintenance costs and other operating expenses.

@John D. - We have a guy :) He's got us covered on the new rules and regulations in PS, and some other buddies in the area are killing it out there.

@Eric A. - Thank you!

@Jessica Chow I know the games that work in PS for now, longer leases with cancellation and related.  Hope they hold out, sounds like they will be selectively investigating a number of smaller acreage properties in the near term.

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