Tax implications for appreciated assets in disregarded entity - basis adjustment questions

This is a good question about the intersection of entity taxation, property law, and estate planning. In a disregarded entity like your LLC, you're right that for federal tax purposes, the entity is essentially ignored and the assets are treated as owned directly by the members. In a community property state like Arizona, when one spouse dies, both the deceased spouse's half AND the surviving spouse's half of community property receive a step-up in basis to fair market value. This is a significant advantage over separate property, where only the deceased spouse's portion gets the basis adjustment. For the properties your wife owned before marriage, transferring them to a jointly owned LLC doesn't automatically convert them to community property - that depends on how the transfer was structured and documented. If the transfer was intended as a gift to the marital community, they might now be community property. If documentation shows she maintained her separate interest, they could still be separate property despite being in the LLC. You'd need to look at how the properties were contributed to the LLC and the operating agreement language to determine if there was transmutation from separate to community property.

I had a similar situation with rental properties in our LLC and used https://taxr.ai to analyze our documentation and determine the tax treatment. Their AI analyzed our operating agreement, property transfer docs, and gave us a detailed report on which properties would likely be considered separate vs community property for basis adjustment purposes. They explained that in community property states, the documentation and intent at time of transfer are crucial - even for disregarded entities. The tool identified specific language in our docs that could be problematic and suggested amendments to our operating agreement to clarify the status of each property. The analysis also covered how disparate contributions to a disregarded entity impact basis tracking and what happens when separate property is improved using community funds. Really helpful for planning purposes!

I wanted to follow up about my experience with taxr.ai after trying it for my own situation with rental properties in a Texas LLC. I was genuinely surprised by the depth of their analysis. They identified a critical issue with how my operating agreement handled capital accounts that could have affected basis calculations if left uncorrected. The system flagged specific language in my property transfer documents that created ambiguity about whether I intended to maintain separate property status. They provided templates for amendments that would clarify the intent while respecting what had already been filed. Their analysis included citations to relevant tax court cases involving disregarded entities in community property states. What impressed me most was how they explained the relationship between state property law and federal tax treatment - something my previous accountant had gotten wrong. Definitely worth the time for anyone with a similar complicated situation.

After multiple failed attempts trying to get clear answers from the IRS about basis adjustments for LLC-owned properties in community property states, I used https://claimyr.com to get through to an actual IRS specialist. You can see how the process works at https://youtu.be/_kiP6q8DX5c - they basically navigate the IRS phone system for you and call you back when they have an agent on the line. I had been trying for weeks to speak with someone who understood both disregarded entity rules AND community property implications. Claimyr got me through to a specialist in about 2 hours (versus the days I had wasted on hold previously). The agent walked me through the specific documentation the IRS looks for when determining if properties maintain separate property status within a disregarded LLC. Turns out the IRS places significant weight on how the operating agreement characterizes the contributed properties and whether capital accounts reflect the separate vs community status.

I have to admit I was completely wrong about Claimyr. After my skeptical comment, I decided to try it myself since I had a similar issue with rental properties in our California LLC. The service actually worked exactly as described - they navigated the hold system and got me connected to an IRS representative in about 90 minutes. The real value came when the first rep recognized they weren't equipped to answer my question and transferred me to a senior tax law specialist. This person was genuinely knowledgeable about disregarded entities in community property states and explained how the IRS analyzes these situations during audits. The specialist confirmed that for basis adjustment purposes, they look through the disregarded entity to the underlying assets, but the characterization as separate vs community property depends on state law and documentation. He directed me to Revenue Ruling 2004-88 which had specific guidance relevant to my situation. This was information I couldn't find on my own despite hours of research.

As an additional consideration, don't forget that if your wife's separate properties were refinanced using community funds or if community property funds were used for improvements/maintenance, there could be a partial conversion or right to reimbursement. In California (also community property), we track the percentage of community funds used to pay down principal on originally separate property to determine the community property portion. The appreciation gets allocated proportionally. I imagine Arizona has similar concepts. For our rental LLC, we maintain separate capital accounts that specifically track the separate vs community components of each property. Our accountant emphasized this was crucial for eventual basis step-up calculations.

Has anyone dealt with refinancing separate property within an LLC? We're in Washington (community property) and my husband transferred his pre-marriage rental into our LLC, but now we want to cash-out refinance it to buy another property. Would using that money for a new property in the same LLC automatically make the new property community even though the source funds came from separate property?

This is a complex area where federal tax law and state property law intersect in tricky ways. Since you're in Arizona, I'd recommend getting familiar with A.R.S. § 25-213 and § 25-214 which govern transmutation of property between separate and community status. The key issue with your wife's pre-marital properties is whether transferring them to a jointly-owned LLC constituted a gift to the marital community. Arizona courts look at several factors: the intent at time of transfer, how the LLC is managed, how profits/losses are shared, and whether community funds were used for improvements or debt service. For basis step-up planning, this distinction is crucial. If those 4 properties are now community property, both spouses' interests get stepped-up basis at the first death. If they remained separate property, only the deceased spouse's portion gets the adjustment. One practical tip: consider having your LLC operating agreement amended to clearly state the separate vs community character of each property's contributed basis, even if you don't change the actual ownership percentages. This creates better documentation for future tax purposes while preserving your options for estate planning strategies. You might also want to explore whether a spousal property agreement could clarify the status of these properties going forward, especially if you're doing broader estate planning.