How to Leverage Loss Deductions When Transferring FLP or LLC Interests

Perhaps like many real estate investors, you hold properties in a family limited partnership (FLP) or limited liability company (LLC). In such a case, you're likely making transfers of ownership interests to family members in an effort to shift income to those

Beware the Pitfalls

Transferring FLP and LLC 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 parents' marginal tax rate to unearned income in excess of $1,900 for 2012. Subject to the tax are children under age 19 and, except for those providing more than half of their own support, full-time students under age 24.)

But this income-shifting strategy can backfire if you're transferring interests in an FLP or LLC holding rental real estate that operating at a loss for tax purposes: You may be transferring losses to a taxpayer whose tax benefit from the loss would be at a significantly lower rate or, worse yet, who doesn't have enough income to absorb the loss.

For example, if you're in the 35% tax bracket and you shift $25,000 in annual losses through a gift to your 25-year-old daughter in the 10% tax bracket, there a 25-percentage-point differential in tax rates, resulting in $5,000 less tax benefit from the loss. Even worse, your daughter may not be able to currently deduct any of the loss because of the passive activity rules.

Unless she qualifies as a real estate professional, the losses will be passive to her. And she 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.

Maximize Loss Deductions

You can still make a gift of an FLP or LLC interest and maximize the benefit of loss deductions. One way is to make gifts via an intentionally defective grantor trust (IDGT).

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 the asset is removed from your taxable estate for estate tax purposes, you 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

As you can see, transfers of FLP and LLC interests to family members can be tricky. Your CPA can help you maneuver through the maze of tax laws, so you can reach your intended goals.