A strategy for buying apartment communities that we haven’t really covered is to purchase the LLC that owns the community. There are advantages and disadvantages to this of course, and Theo will break those down in detail on today’s episode of Syndication School. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Theo Hicks: Hi, Best Ever listeners. Welcome to the Syndication School series, a free resource focused on the how-to’s of apartment syndication. As always, I am your host, Theo Hicks. Each week we air two Syndication School series episodes, every Wednesday and Thursday. They can be found in audio-only form on the podcast, as well as video on YouTube. We focus on a specific aspect of the apartment syndication investment strategy.
For the majority of these series we offer some sort of resource for you to download for free, whether it be a PowerPoint presentation, Excel template, Word document, PDF document – something that accompanies the episode that you can use as a resource to download for free. All of these free resources, as well as free Syndication School series, can be found at SyndicationSchool.com.
Today we are going to be talking about the membership interest transfer. So we’re gonna be talking about the who, what, when, where, why and how of this thing called the membership interest transfer.
Now, simply put, the membership interest transfer is a method of acquiring an apartment – in this case an apartment, but it technically can be used for residential as well – either all-cash or with a loan, and using this method, you’re able to 1) shield the purchase of the property from the general public, so it’s not going to be a matter of public record, it’s not going to be something that shows up on the auditor or appraisal site, for example, of the properties owned by ABC LLC, and you implement this membership interest transfer, then it will still say it is owned by ABC LLC on the appraiser site.
The second thing that happens when you use the membership interest transfer is that it is a tax-exempt transaction, which means that instead of the property being directly transferred to the buyer, the seller’s membership interest in the property is transferred into a new entity created by the buyer… And because of this, you’re able to preserve the current tax evaluation of the property upon acquisition. This isn’t permanent, but if the current owner is paying $100,000 in taxes based on the ownership of this property in their LLC, then once that ownership is transferred to your LLC, you’ll still be paying that $100,000 until you have your next appraisal. So that’s quickly the What of the membership interest transfer.
Moving on to the next step, which is Who should use the membership interest transfer. Real estate investors who are wanting to shield the purchase price of the acquired property from anyone who might be interested in knowing what was paid for the property can use the membership interest transfer. This is one example.
Investors who would like to, for example, buy and flip a property… So if you’re planning on buying this property and it is highly distressed, and you want to implement a quick value-add business plan and then quickly resell the property at a profit, this might be a strategy that you want to implement. Because if you’re looking to get into a deal at value, and then turn it around in a quick period of time, this could be beneficial… Because typically, when a property is listed for sale – if you look at it from your perspective, if you’re looking at an apartment for sale you need to know questions ask when buying an apartment, one of the first things that at least I do is I go to the appraiser site, I type in the property address, and I look to see when the property was last bought and at what price it was bought at. That way, if I see that it was bought a year ago, and they’re trying to sell it for a 50% uptick, I can ask them why they’re doing that.
But when you are using this strategy, no one knows what you paid for it originally because of the membership interest transfer. So the number isn’t on there, that way you’re not gonna have any of those conversations of “Hey, you bought this property a year ago. Why are you selling it for so much more one year later?” or “Why are you selling it one year later in general?”
Another example of Who should use a membership interest transfer is someone who is wishing to preserve the current tax evaluation of the property that is being acquired. Typically, when a property is purchased above its current tax evaluation, which is the majority of the time, the auditor will shortly after the purchase reevaluate the property, and will do an evaluation of that property for tax purposes. For the times when the property is purchased for a below tax evaluation, there are a few more steps that must be followed to get the county to modify its valuation, like appealing the value, showing that it was a fee-simple transaction at a below valuation price.
This should remedy the problem fairly quickly, because the auditor and the board of revision cannot argue with an arm’s length transaction, which is what this membership interest transfer is. However, when a property transacts at an above valuation price, say in the case of a property that’s purchased in an extremely distressed state was turned around through management and value-add and through numerous upgrades, the seller deserves the upside of doing that. The buyer may be willing to pay for this upside, however a barrier to transaction with the seller’s desired purchase price is the tax evaluation basis, which means that you might have issue buying the property at the purchase price because of the fact that you know taxes are going to go up once you’ve implemented your value-add business plan.
Upon the sale, the auditor and the board of revision will immediately jump the tax evaluation of the property from its lower taxation basis to its newer, higher basis, because of the fact that it was an arm’s length transaction. The problem here is that it may appraise for a higher price, but when it comes time to transact the property, a new buyer is going to look at the purchase price taxable value instead of the current taxation basis, which messes up the future sales price of the property.
So all that is avoided by doing the membership interest transfer, because they can’t see the purchase price anyways, and you’re able to preserve that current tax evaluation.
I know it was a mouthful, but I’m actually reading this straight from a broker who specializes in these types of transactions, and that’s the wording that he used.
So when should a membership interest transfer be used? The best time to use this method is when an investor wishes to keep the price that was paid for the property confidential. If the purchase price of the property is above the taxable value, as I just explained, and the buyer wishes to shield the purchase price, they may elect to use the membership interest transfer, and we’ve just explained why you wanna do that if you’re buying the property above the current taxable value.
Where can a membership interest transfer be used? It can be used in any real estate transaction where the purchase price is higher than the current taxable value. To this individual’s knowledge, this method is legal in all 50 states, but like any legal advice offered, we’re not attorneys, and this person’s not an attorney; we have no legal training whatsoever, so if you are gonna do this method, make sure you don’t do it on your own, and consult with an attorney in your state, your real estate attorney, before you do this, just to see if there’s gonna be any other unintended consequences by implementing this strategy.
Why is the membership interest transfer used? It is used to shield the purchase price of real estate, as we’ve mentioned a few times in this episode so far.
In the case of avoiding the increased tax evaluation, the effect, as I mentioned, is not permanent. So it’s not like you’re always gonna be taxed at that lower valuation. Typically, the taxes are reevaluated every 3-4 years. When they see a transfer in ownership, which means that they see a change in the name on the title, as well as a change in the tax mailing address, which is what you see in the public record, that is usually an indication that a change in ownership has taken place from the perspective of the auditor… Which isn’t technically always the case. Maybe there were two partners and they’ve split, or maybe they moved offices… But overall, if there is a new entity name or a new mailing address, the auditor assumes that the property was transferred, which means that they might go in there and audit it right away.
When the auditor does come calling, demanding that you pay more for the property than you are currently paying, because they think it’s worth a certain value, he’ll not have the fee simple transfer of the property as evidence of the value… Which means that he won’t have the purchase price that you paid as evidence. Instead, he will have to dig deeper to prove why he thinks the property is worth a certain amount, using an appraiser or some other valuation method – income approach, sales comp approach. It’s a little bit harder for them to come up with a new valuation of the property, because they don’t have whatever the purchase price that you paid for as evidence. So that’s another reason why the tax benefits, but again, it’s not permanent; eventually, the tax guy is going to have evidence to increase the rate… But again, taxes cost a lot. Taxes are a pretty large portion of the expenses paid for a property, so the longer you can delay that increase, the more money you can make on the deal.
How is the membership transfer used? It occurs as follows — and again, this is gonna be some technical jargon, because this is what the individual that talked to me about this strategy said.
Number one, a contract addendum is drafted, outlining the purchase between buyer and seller will now be conducted as a membership interest transfer between the respective parties. The entity being sold is a newly-created LLC, with a name chosen by the buyer, that will be formed in the Secretary of State’s office, with the seller’s LLC as a sole member of the entity. This formation must occur before the closing, and the sooner, the better.
In the contract it says “Hey, we’re doing a membership interest transfer. Hey, me, buyer man, has created an LLC”, and that’s what the property will be transferred into at closing. And this must be done before closing, obviously.
Two – an operating agreement for the newly-formed entity will then be signed and executed by the seller’s LLC by and through its authorized members prior to closing, establishing the new entity’s governance. So the seller has to sign some documents in order to actually execute the transfer.
Three, a deed and affidavit in support of tax-exempt transfer will also be executed at the same time as the operating agreement by the seller’s LLC, transferring the property into the newly-formed LLC… Which, along with any personal properties associated with the property that is currently included with the sale will be the new entity’s sole asset. The deed will be recorded with the Recorder’s Office prior to closing. The affidavit will tell the auditor the transfer is not taxable as a transfer to an entirely solely owned by the granting entity. This is a specific tax-exempt transaction outlined by – in this case – the Ohio Revised Code, or whatever state that you’re living in. Basically, you’re not only signing an operating agreement, but also an affidavit that this is indeed tax-exempt because of the fact that you’re transferring it to an entity.
By recording this deed in advance and transferring the membership interest and the property itself at closing, the seller will save on conveyance tax that the county would have charged if the transfer of the property had been made to a third-party. So even more tax-saving.
Number three, a membership interest transfer agreement, resolutions, a bill of sale and any and all other documents necessary to transfer the membership interest held by the seller’s LLC in the newly-formed LLC over to new LLC will be executed on the day of closing. Disbursement of funds will follow the normal closing process for a sale of real estate, but the property being sold on the settlement statement will be referred to as the 100% membership interest in the entity.
Four, the buyer’s LLC will become the sole owner of the newly-formed entity, the membership interest transfer, and will execute a mortgage and any other required document to its lending, securing the purchase in the newly-formed entity’s name. We’re just talking about the process of securing financing, and how it’s basically the exact same, except rather than it being a person, it’s an entity.
The county will simply have made a transfer for no consideration on its books, and barring any meddling from outside entities, will continue to value the property at its current appraised valued for taxation purposes. The purchase price for the membership interest will not increase the taxable value of the property in the auditor’s records. Future tax savings are not possible to calculate, but future savings are possible. And again, it’s going back to the fact that the taxman doesn’t have access to the purchase price, so they cannot use that as evidence when increasing taxes.
Six, the cost of the membership transfer agreement documentation and filing is approximately $1,200 to $1,500.
Seven, no liability will be assumed by the buyer for the seller’s current entity’s potential liabilities, nor will the seller’s current LLC retain any liabilities for the newly-formed entity.
That is just a very fancy way of outlining how the process actually works, but again, you’re gonna be using an attorney for all of this anyways, so this is just something for you to reference and understand “Hey, this is what should happen.” But again, make sure you’re speaking with your attorney before you are pursuing this option.
Now, the last thing I wanna talk about is a quick common question that this broker typically gets when discussing membership interest transfers. The question is “Will the new buyer take on the original basis of the previous owner?” For instance, if a property is sold for 12 million dollars to a new buyer, but the buyer took title to it at an evaluation of 2 million dollars, will the new buyer (the one who bought it for 12 million) would his basis be for 2 million? And the new answer is no. The new buyer’s basis, as far as the IRS and the state are concerned, when it comes to capital gains, own the asset for 12 million.
If they acquire that property via a 1031 exchange, then their basis would be based on the chain of transactions in the 1031 exchange, not the previous owner’s taxable basis for capital gains purposes.
Essentially, what he’s saying here is that the basis is not based on whatever the seller had bought the property for. In this example, the seller had bought the property for 2 million, but you bought it for 12 million; is your basis 2 million or 12 million? Because, again, if they can’t see the purchase price, does that count towards your basis? The answer is yes; you own the asset for 12 million dollars, and when it comes to capital gains tax, you own the property for 12 million, not 2 million. So that’s something that you cannot do. You can’t lower your basis by using this strategy.
The two benefits are 1) the shielding of the purchase price, and 2) the avoidance or at least the delay of the increase in taxes.
I’m going to put this document that I have referenced as a free document for you to download. That way you can kind of read through all this yourself. It’s got the contact information of the individual who wrote the document, or at least helped me write the document, so that if you have any extra questions, you can contact them.
But again, overall, the membership interest transfer is a way for you to buy a property without you technically actually buying it, and instead transferring it into an LLC, with the two benefits of shielding the purchase price and delaying the increase in taxes.
That concludes this episode on the benefits of buying the LLC that owns an apartment. Technically, it’s a transfer, but it’s kind of the same thing. I guess you’re buying the LLC or you’re buying the ability to transfer the asset from one LLC to another LLC.
But in the meantime, make sure you check out some of our other Syndication School series on the how-to’s of apartment syndication. Download the free document that I referenced throughout this episode. All those can be found at SyndicationSchool.com.
Thank you for listening, and I’ll talk to you tomorrow.