Tax Basis - Property Inherited Via an LLC

[L-1]

State of California

in 1985, a single family residence was purchased for $181.5k. It was used as a family home untii 1994, when the original owner moved out and converted it to a rental. In 2012, the same owner moved ownership of the property out of his name and into that of an LLC he owns.

California has Prop 13, which for tax purposes places severe limits on the assessed value of real estate (even with the transfer to an LLC). 34 years later, the property is only assessed at around $375,000 for tax purposes, while the house is actually worth a little over $2 Million.

In his will, the owner plans on leaving the LLC rather than the property to a friend. Should his friend sell the property and dissolve the LLC, how will the basis be determined for the house's value?

Thanks!

[flyingron]

All the Prop13 nonsense has nothing to do with basis or capital gains. It only affects how the property taxes are assessed.

The basis for this property is likely NOTHING. When it was converted to rental use, you were required to depreciate it and it is assumed you did whether you actually took the tax deduction or not at the time.
Further, there's no exclusion or step up in basis in this circumstance as near as I can see.

So pretty much the capital gain is going to be pretty close to what he sells the property for (less any last-minute improvements for the sale and the various costs of the marketing/sale).

[Taxing Matters]

In his will, the owner plans on leaving the LLC rather than the property to a friend. Should his friend sell the property and dissolve the LLC, how will the basis be determined for the house's value?

Thanks!

For federal income tax purposes the outcome will depend very much on the details of the LLC that owns the property. If Joe is the sole owner of the LLC then the default rule for for federal income tax purposes is that the LLC is an "entity disregarded as a separate from its owner" (which tax lawyers call a disregarded entity for short) which means that for federal income taxes the LLC is ignored and the property owned by the LLC is treated as though Joe owns the LLC's property (including the home) directly. Joe could elect for the single owner LLC to be treated as a corporation, which in that case federal tax law treats the corporation as the owner of the property rather than Joe. This makes a huge difference in how the basis of the property is treated when Joe dies.

If the LLC is a disregarded entity (i.e. no corporate election was made for it and it has just one owner) then when Joe dies the current fair market value (FMV) of the home is included in his gross estate for federal estate tax purpose and the home's basis also becomes the FMV of the home on the day he died. Joe gives that LLC to his his friend Becky in his will. Because Becky gets a disregarded entity from the estate, the IRS sees her as the owner of the property. If she then dissolves the LLC that has no effect under federal tax law because the LLC is disregarded anyway. If she then she sells the property right away, her capital gain would be a long term capital gain and the amount of the gain would be the difference between the net sales sales price (what she gets after selling expenses) less her basis, which is the FMV of the property the day Joe died. It works out the same if she has the LLC sell the property and then dissolves, with Becky getting the cash the LLC has. So if the home is worth $2 million on the day Joe died, Becky gets the home with a basis of $2 million in this example. If she then sells the home for that same amount, $2 million, she has no capital gain and pays no tax.

But if the LLC is treated as a corporation, the result is different. Then when Joe dies it is the ownership interest in the LLC that gets the step up in basis, not the home. I won't walk through all the steps of what happens here as it can get involved, but the bottom line will be that there would be gain recognized on the sale of the sale of the property that would be the difference between the net sales price and the basis. And here, the basis will start with the $181.5k that Joe paid for the property, plus any additions to basis for improvements he made to over the years and less the depreciation he took or could have taken on it while as a rental. While the basis would be pretty low, it would not be zero (as FlyingRon stated) because only the building and other improvements to the property may be depreciated. The land itself cannot be depreciated.

The result will be the same for California income tax, too.

The assessed value for California property tax has NOTHING at at all to do with how the gain is computed for income tax purposes.

By the way, Joe likely should have a revocable living trust and have the LLC owned by the trust rather than passing the LLC to Becky via his will. With assets of $2million plus Joe would want to see an estate planning attorney for assistance.

All the Prop13 nonsense has nothing to do with basis or capital gains. It only affects how the property taxes are assessed.

The basis for this property is likely NOTHING. When it was converted to rental use, you were required to depreciate it and it is assumed you did whether you actually took the tax deduction or not at the time.
Further, there's no exclusion or step up in basis in this circumstance as near as I can see.

You missed two important things here, Ron. First, that a single member LLC is disregarded for federal income tax purposes so the home is treated as owned by the LLC owner directly. When the owner dies, the home gets the basis step up because for federal income tax the decedent is viewed as having owned the home directly. Second, if there had been no basis step up at death the basis still would not be zero even after full depreciation because only the building/improvements are depreciated, not the land.

[L-1]

Thank you Taxing. And yes, the LLC was a disregarded entity and placed in the name of the Living Trust. I failed to mention that. (All this stuff gets so complicated its hard to remember all the relevant facts you need to include when you post a question.)

Again, thank you.

[Taxing Matters]

Thank you Taxing. And yes, the LLC was a disregarded entity and placed in the name of the Living Trust. I failed to mention that.

If the trust is a grantor trust then the result would be the same as if Joe owned the LLC directly because the grantor trust is also pretty much disregarded for federal income tax purposes. The trust is a grantor trust if Joe retained the power to revoke the trust at any time (a revocable living trust) or if Joe retained certain other significant powers over the trust. If the trust is not a grantor trust then the outcome will be more like that of having the property owned by a corporation and there would be no step up in basis when Joe dies.