How to purchase a portfolio and avoid tax penalties

Question

I'm a realtor who helps investors to purchase income properties.  One of my clients is looking to purchase the entire portfolio (51 doors) from a seller.  The seller is looking to avoid paying a large chunk in taxes.

I have limited knowledge of buying a portfolio.  Are there strategies that would be mutually beneficial to both sides other than a straight purchase and sale?

Could the seller put the assets into an LLC and then allow the buyer to purchase the LLC over an X year period work?  I'd like to be more knowledgeable about creative strategies and appreciate any feedback.

Jon Holdman · Answer

That wouldn't change the tax consequences of the sale.  Buying the LLC units over time would be equivalent to seller financing.

They have an asset that has gains.  They want to sell it and pocket all the returns.  Don't we all?  Real estate get preferential tax treatment (vs. ordinary income).  Even the 25% cap on unrecaptured depreciation is preferential.  They really have three choices:

• Pay the tax right now, pocket what's left.
• Spread out the tax bill with seller financing.
• Defer the tax with a 1031, continue to get the income from the replacement, let your heirs take it with the stepped up basis.

I've had this discussion with my accountant.  There's really no way to avoid the taxes other than the 1031/die/stepped up basis strategy.

Dave Foster · Answer

@Michael Liddicoat, I think everyone here is coming at you from the same direction.  Any sort of manipulation other than a 1031 exchange is going to result in a tax consequence although an installment sale or sale of membership interest of an LLC can spread out some of that.

However, I think there's one compelling reason to explore the LLC route anyway if the buyer has good financing capability if they do not want to pursue a 1031.  @Basit Siddiqi makes a good point about the norm being the purchase of a property from an LLC.  But thats exactly what seller and buy may want to avoid if they're not doing a 1031.  The sale of membership interest in an LLC does not require a real estate closing with title insurance etc.  This can save significant funds in closing costs by selling the company rather than the real estate owned by the company.

If they want to do a 1031 then they are stuck selling the properties to the buyer.  Selling the membership interest in a multi asset LLC would not qualify for 1031 treatment.  So the LLC will need to sell the assets and 1031 into another instrument which can be compatible with 1031 but be completely passive and allow them to generate income on the deferred tax and deferred depreciation recapture for the remainder of their lives.

Michael Liddicoat · Answer

@Basit Siddiqi

I'm still learning some of these investment tools and strategies so any miscommunication was on my end.  Thank you for clarifying.

Basit Siddiqi · Answer

@Michael LiddicoatAre you trying to suggest something likeSeller and Buyer are member's of an LLC where the seller contributes all the property into the LLC?Would the operating agreement call for 100% profile/loss/capital to the seller and 0% for the buyer and it would be suggested that the buyer buys a certain percentage of the LLC from the seller every year?

This is probably a more complicated measure of seller financing because the real estate can be destroyed and the buyer would back out or the assets would appreciate significantly and the seller would request more money.

In the above case - I guess the buyer could buy the rights to the income from the seller until he brought out 100% of the LLC.

50 is still a young age - I was thinking they would benefit from deferring the gain as a result of inheritance and getting a step up of basis for their heirs.

Sorry if I misunderstood your LLC scenario.

Michael Liddicoat · Answer

@Basit Siddiqi

The sellers are in their 50's and looking to unload all their properties.  They have a listing agent involved who will probably try to kill the idea of seller finance, but that's an assumption on my part.

I didn't know if creating an LLC with the sellers and buyer as members, bringing the assets under the umbrella and then allowing to the buyer to buy the sellers out would work.  This would mean that there is no history of the LLC that the buyer is unaware of.

I'm probably making many assumptions here about the liability exposure and relationship that the buyer and seller would want to have.

Michael Liddicoat · Answer

@Jon Holdman

Thank you for the feedback.  I wasn't sure if there was another option.  Glad to know I'm not the first one to ask.

Basit Siddiqi · Answer

@Michael Liddicoat

The seller can accept seller financing(installment plan).This would allow the seller to report gain and pay taxes over a period of time instead of all at once.The downside for this is that gain attributable to depreciation recapture is taxed upon year of sale.

An alternative would be to do a 1031 exchange. This would allow the seller to defer the gain. However, the seller will need to acquire like-kind property.Normally people want to acquire the property outright instead of an LLC that holds property. The reason for this is that the buyer of an LLC may find himself subject to some lawsuits down the road.

How old is the seller?

How to purchase a portfolio and avoid tax penalties

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