Can I set-up an LLC for a commercial real estate investment with different allocations of depreciation, losses and profits for various investors?
Contact your CPA, Tax Attorney and Legal Advisors – we do not provide tax or legal advice.
There are multiple limitations under the IRS’s partnership rules on the ability to utilize the losses.
This is a very complicated question, because the rules on allocating losses, although they sound simple in fact are not.
First, you must have tax basis in the entity allocating you the losses for which to claim the losses against. This generally means that your cash investment in the partnership plus your share of partnership debt must be at least equal to the amount of losses being allocated to you.
your cash investment in the partnership + your share of partnership debt must be at least equal to the amount of losses being allocated to you
Second, to the extent you are relying on the debt allocation to provide you basis to claim the losses, you must be considered at risk with respect to that debt or the debt is “qualified non-recourse debt”. In order to be at risk with respect to the debt you must be personally liable for the repayment of the debt.
“Qualified Non-Recourse Debt” is debt owed to an unrelated third party, which is secured by real estate in which no person or entity is liable for the repayment of the debt.
Thirdly and assuming you cross these two hurdles, you can specially allocate losses between members, only if the allocation has substantial economic effect. Which means that the losses being specially allocated must impact the partner receiving the losses economically and be reflected in their capital account with the LLC for commercial real estate.
Non-recourse deductions: which are deductions funded by non-recourse debt (such as depreciation on a building funded with non-recourse) are allocated based on the entities profit sharing ratio. So, in order to specially allocate depreciation supported by non-recourse debt you profit sharing ratio would need to be the same percentage as well.
Finally, you must get by the passive loss rules.
Real Estate Professional Rules for LLC Members to Realize Active Losses
The real estate professional rules only allow you to deduct losses with respect to real estate activities in which you materially participate (you spend more than 500 hours managing the property) or you meet the significant participation rules and you can aggregate enough significant participation activities to surpass the 500 hours material participation rule. Significant participation is define as spending 100 hours or more time managing an activity but less than 500 hours in total. (See our special section on setting up an LLC for asset protection.)
You would aggregate all activities that meet this criteria and if the total time spent is more than 500 hours then you are considered to materially participate in the aggregated activities and the losses would be deductible under the real estate professional rules.
Example: you own and interest in 5 rental properties (A,B,C,D, & E) with respect to properties A, B, C, & D you spent 150 hours per year in the active management of the properties. With respect to E you are not involved, in the day to day active management of that property, so your total hours spent with respect to this property are 25 hours per year. A,B,C, & D, can be aggregated and your total hours would be 600, so losses from those properties could be deducted under the real estate professional rules. Property E would stand by itself (you can not aggregate since your time is less than 100 hours) and therefore Property E’s losses would not be deductible under the real estate professional rules, but would be subject to the normal passive loss rules.
With respect to prorating losses, you could only be allocated losses for the period of time that you have an ownership interest in the entity generating the loss. The proration can be based on either numbers of days you own the interest, i.e. x divided by 365 times loss, or based on specific accounting which requires a closing of the books as of the day before you become a member.
YOUR ATTORNEY AND CPA WOULD LIKELY NEED TO REVIEW THE OPERATING AGREEMENT OF THE ENTITY IN WHICH THE INVESTMENT IS BEING MADE PLUS UNDERSTAND ALL OTHER FACTS RELATED TO YOUR INVESTMENT INCLUDING ANY SIDE AGREEMENTS, BEFORE THEY COULD OPINE WHETHER THE LOSSES ARE IN FACT DEDUCTIBLE ON YOUR RETURN.