Understanding the Tax Challenges of Real Estate Property Contributions

A common way to form a partnership is through a contribution of real property. Real property owners may need an influx of cash to ready their property for sale but would prefer not taking out a loan. This is where a cash partner can create the liquidity real property owners may need.

Historically, real estate has increased in value over time, and real estate professionals understand how to pick the right properties at the right time. However, property contributions can create very complicated tax implications that most real estate professionals may not realize. This is where tax professionals can support property owners in navigating the daunting world of tax.

Property Contributions Creating Built-in Gain/Loss

For tax purposes, when you contribute property worth $1 million, you do not automatically receive $1 million of tax basis in the partnership. The worth of the property, or fair market value (FMV), is what is known as your 704(b) basis in the partnership, which does not have an immediate taxable impact. Your tax basis, on the other hand, is your original purchase price (plus any improvements, less any depreciation previously deducted). The IRS designed contributions this way to prevent property owners from not paying taxes on their gains while receiving the full benefit for tax purposes within the partnership.

When you have a difference between FMV (704(b)) and tax basis of your property contribution, it results in a deferral of the hypothetical gain/loss you would have recognized had it been sold for FMV. This is known as a built-in gain/loss, which is recognized by the contributing partner once the partnership no longer holds that property (e.g., sale, disposal, distribution, transfer).

Sale Transaction Example of Contributed Property

Harrison contributes land worth $500K to Harrison Sweeney, LLC (HS). His original cost of that land was $250K. Sweeney contributes $500K of cash to HS. Each are 50/50 partners in HS. HS uses all $500K of cash to develop the land into multiple residential lots and sells them all three years later for $2,750,000.

How much gain will be allocated to Harrison?

• Harrison would have recognized a $250K gain at the time of contribution had his land been sold for FMV. This $250K gain will be deferred until HS no longer holds the property.
• HS’ total basis in that land just before it was sold is $750K (original $250K basis from Harrison and $500K in cash from Sweeney used to develop the property).
• As a result, HS would recognize a $2 million gain, which would be passed through to its partners.
• In the end, Harrison would be specially allocated an extra $250K of gain, which is shifted away from Sweeney. This results in Harrison being allocated a gain of $1.125 million and Sweeney 875K.

Below is a visualization of the above example:

Real property contributions and subsequent sale of that real property can create complicated tax issues which require the assistance of a tax professional. Things get even more complicated when depreciable property is contributed to a partnership. Speak to a Weaver professional today for assistance with your property contribution or sale transaction.

Authored by Chris Andrews

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