The traditional method for buying an apartment community involves the direct transfer of ownership from the seller to the buyer. In this type of scenario, one or both entities may be an LLC or another entity, and the result is the same. The property will transfer at closing to the buyer listed on the sales contract. At that time, the sales price and the change of ownership are recorded and become a matter of public record. While this is the traditional method of conveying property, it is not the only option. In some cases, it also may not be the best option.
Generally, a tax auditor or assessor will review a property’s taxable value every few years or when a sale is recorded. This means that the property may have been taxed at a lower-than-market value before the sale. After the sale, however, the property’s tax bill may shoot up and be aligned with the sales price.
While the new buyer has likely anticipated this increase when creating projections for future operating expenses, this sharp and immediate increase in tax liability may be avoided through a membership interest transfer. A membership interest transfer essentially is a method where the property’s ownership is transferred from one LLC to another LLC. Because the entire transaction is completed within the confines of the LLC’s structure, the purchase price and the change of ownership are not a matter of public record. Nobody who was not involved in the transaction will know what the sales price was or when the transfer took place.
This type of transfer may be advantageous in a few specific scenarios. One of these is a buy-and-flip situation. After you invest your time, energy, and resources into fixing up a rundown property, you want to sell the property for its current market value. You do not want a buyer to be able to see what you bought the property for, how long you have owned it, and what your profit margin will be. A buyer who is privy to such details may have many questions related to repair costs, the value of the improvements that have been made, and other factors. Through a membership interest transfer, these details are not presented to the buyer. The buyer will then make an offer based on the property’s current condition and relevant comps.
In many areas, commercial real estate values are reassessed every three to four years. The exception is if the property is sold. After a sale, the recorded sales price often becomes the taxed value. This means that the new owner’s tax expense could be significantly higher than the seller’s tax expense. If the new sales price could be kept out of public records, such as by buying the LLC, the new buyer could potentially save money on taxes for the first few years of ownership. Because of how considerable tax liability can be, this could save the buyer a sizable amount of money until the property’s value is reassessed.
Eventually, the property’s value will be reassessed even if the membership interest transfer is used. When a bill of sale is recorded, the sales price usually becomes the new tax value. If no recent sale is recorded when it is time to reassess a property’s value, comps and other supporting data must be researched and analyzed. The burden of defining the new value falls on the tax assessor’s or auditor’s shoulders.
Keep in mind that a membership interest transfer may be legal in all states, but you should consult with an experienced real estate attorney about the process and about structuring it legally. Generally, the buyer will establish a new LLC before closing, and the seller’s established LLC will be listed as the sole member of the new LLC. The deed can be recorded prior to closing to avoid conveyance tax, and this is an additional saving to the buyer.
At closing, the membership interest transfer will be executed. In addition, the bill of sale and other documents related to the transfer of ownership will be executed. Funds related to the sale will transfer at that time as well. Because the property will be owned by the new LLC at closing, the commercial real estate financing process is the same.
Some people are worried that buying the LLC rather than the apartment community would impact their tax basis. However, this concern is unfounded. The seller’s tax basis does not transfer to the new entity. Because of this, buying an LLC would not expose you to additional taxes related to the tax basis.
Investing in commercial real estate can be lucrative, and it may be even more lucrative if you can delay a hike in property taxes for a few years or optimize your return when flipping the property. Whether you intend to use a membership interest transfer as part of a fix-and-flip scenario or to mitigate your property tax liability, you should carefully review your specific scenario with your real estate attorney and with your accountant. Understanding the full implications and benefits of a membership interest transfer when investing in a multifamily community is essential in order to reap the rewards and mitigate risks.