It’s not uncommon for real estate investors to hold properties in a family limited partnership (FLP) or family limited liability company (FLLC). Many such people also likely transfer ownership interests to family members to “shift” income to family members in a lower tax bracket or to transfer wealth to the next generation. Even though the economy has improved over the past several years, some FLP or FLLC properties may be generating operating losses. This can cause pitfalls for real estate investors.
What are FLPs and FLLCs?
An FLP is a type of limited liability partnership in which only members of the same family can be partners. The FLP will have both general partners (who run the business) and limited partners (who have no say in the day-to-day operations). Most important, the limited partners aren’t liable for the partnership’s debts beyond their contributed capital.
In an FLLC, the family members own the entity and can choose whether to act as managers. All family members have limited liability regardless of their status as a manager.
What are Some Pitfalls?
Transferring FLP and FLLC interests to family members can provide opportunities to shift taxable income from a higher-income-tax-bracket taxpayer to a lower-bracket one, as long as the recipient isn’t subject to the “kiddie tax.” (The kiddie tax is applied at the recipient’s parents’ marginal tax rate to unearned income in excess of $2,100 for 2016. Children under age 19 and, except for those providing more than half of their own support, full-time students under age 24 are subject to the tax.)
Beware, though: This income-shifting strategy can backfire if you’re transferring interests in an FLP or FLLC holding rental real estate that’s operating at a loss for tax purposes. In this situation, you may be transferring losses to a taxpayer whose tax benefit from the loss would be at a significantly lower rate or, even worse, who doesn’t have enough income to absorb the loss.
For example, if you’re in the 35% tax bracket and you shift $35,000 in annual losses through a gift to your 25-year-old son in the 15% tax bracket, there’s a 20-percentage-point differential in tax rates, resulting in $7,000 less tax benefit from the loss. Even worse, your son may not be able to currently deduct any of the loss because of the passive activity rules.
Unless he qualifies as a real estate professional, the losses will be passive to him. And he may not have any passive income and, as a result, likely won’t qualify to deduct the loss. You, on the other hand, may have passive income to absorb the loss or qualify as a real estate professional for whom real estate activity losses are deductible against ordinary income.
How Can You Maximize Loss Deductions?
So what can you do? You can still make a gift of an FLP or FLLC interest and maximize the benefit of loss deductions. One way is to make gifts via an intentionally defective grantor trust (IDGT).
How do you do this? Instead of transferring the interest to an individual, you transfer it to the IDGT, which is designed to be a completed transfer for gift and estate tax purposes, but not for income tax purposes. So, while you’ve removed the asset from your taxable estate for estate tax purposes, you’ll continue to get the benefit of the losses from the interest owned by the trust. (Note that you also will continue to pay tax on any income the trust assets earn.)
Professional Help Helps
This article just touched on the basics of transfers of FLP and FLLC interests to family members. Note that recently released proposed regulations may significantly impact certain gifting strategies commonly used with FLPs and FLLCs. This new development, combined with the fact that FLP and FLLC issues can be complex, underscores that the advice of a CPA and other professionals will be particularly important as you determine whether an FLP or FLLC is right for you and your family.