Can I Use Family Limited Partnerships (FLPs) to Minimize CRE Gains? (w/Examples) + FAQs

No, a Family Limited Partnership (FLP) is not a tool for minimizing or deferring capital gains taxes when you sell commercial real estate (CRE). Its primary power is in drastically reducing federal estate and gift taxes, which are often a much larger threat to your family’s wealth. The core conflict this strategy addresses stems from Internal Revenue Code § 2036, a rule that allows the IRS to pull assets you’ve given away right back into your taxable estate if you retain too much control or benefit. The immediate negative consequence of violating this rule is the complete failure of your estate plan, potentially triggering a 40% federal estate tax on the full, undiscounted value of your CRE portfolio.

This is not a small problem; for estates over the federal exemption, every $10 million in assets could trigger a $4 million tax bill, a significant loss of generational wealth. This guide breaks down exactly how to use an FLP correctly to navigate this complex rule and secure your family’s legacy.

Here is what you will learn:

🏢 The True Power of an FLP: Understand why an FLP’s real value is in slashing estate taxes through valuation discounts, not avoiding capital gains on property sales.
⚖️ The Two-Sided Coin of Liability: Learn how the unique roles of General and Limited Partners create both immense control for you and powerful asset protection for your heirs.
🚫 Avoiding the IRS’s Deadliest Traps: Discover the critical mistakes that cause the IRS to disregard an FLP, based on real Tax Court cases, and how to avoid them.
🗺️ Your Step-by-Step Blueprint: Follow a detailed guide to correctly form, fund, and operate your FLP to ensure it stands up to scrutiny.
🆚 FLPs vs. The Alternatives: See a clear, side-by-side comparison of FLPs, LLCs, and Trusts to determine the absolute best tool for your specific goals.

The Core Problem: A 40% Tax on Your Life’s Work

When you pass away, the federal government can levy an estate tax on the total value of your assets. For 2025, an individual can pass on approximately $13.99 million tax-free, but this exemption is scheduled to be cut in half after 2025. Any amount above this threshold is taxed at a staggering 40%.

For a family with a $20 million CRE portfolio, this could mean millions of dollars in taxes, forcing your heirs to sell properties just to pay the bill. The central challenge is transferring this wealth to the next generation without losing a huge portion of it to the IRS. This is where the FLP comes in, but not in the way most people think.

Deconstructing the FLP: Understanding the Engine of Wealth Transfer

A Family Limited Partnership is a legal entity you create under state law, much like a small business. It is owned exclusively by family members and is designed to hold assets like your CRE portfolio. The entire structure, and its powerful benefits, are built on the foundation of two very different types of partners.

The Two Classes of Partners: Control vs. Passive Ownership

The FLP intentionally separates management power from economic ownership. This division is not just a formality; it is the legal distinction that creates the tax-saving opportunities and asset protection benefits.

General Partners (GPs): These are typically the senior family members, like parents or grandparents, who contribute the assets. The GPs have 100% of the management control. They make all decisions: when to buy or sell property, how to manage tenants, and, most importantly, when or if to distribute cash profits to the partners. This absolute control comes with a serious trade-off: GPs have unlimited personal liability for the partnership’s debts.
Limited Partners (LPs): These are typically the children and grandchildren who receive their ownership interests as gifts. LPs are passive owners with zero management control. They cannot force the GP to sell a property or demand a cash distribution. In exchange for giving up all control, LPs are granted limited liability, meaning their personal assets are safe from the FLP’s creditors. Their financial risk is capped at the value of their interest in the partnership.

This deliberate imbalance—total control and total risk for the GP, no control and no risk for the LPs—is the key. The law recognizes that an LP’s interest, burdened by a lack of control and no ready market to sell it, is worth less than its direct slice of the underlying real estate. This difference in value is where the magic happens.

The Real Tax Advantage: It’s Not About Capital Gains, It’s About Your Estate

Many investors believe an FLP helps them avoid capital gains tax when a property is sold. This is a critical misunderstanding. The FLP is a “pass-through” entity, meaning any capital gains from a sale flow through the partnership and are taxed on each partner’s personal tax return.

The true, and far more powerful, tax benefit of an FLP is its ability to dramatically reduce your federal estate and gift tax liability through a mechanism called valuation discounting.

The Power of Valuation Discounts: Making $1 Million Worth $650,000 for Tax Purposes

When you gift an LP interest to your children, you must report its value to the IRS. Because a limited partner has no control and cannot easily sell their interest, a qualified appraiser can assign a discounted value to that gift for tax purposes. This is the engine of the FLP strategy.

There are two main types of discounts that are applied together:

Discount for Lack of Control (DLOC): This reflects the LP’s powerlessness. A hypothetical buyer would pay less for an interest that gives them no say in management, no ability to force distributions, and no power to liquidate the assets. This discount can often range from 15% to 40%.
Discount for Lack of Marketability (DLOM): This reflects the fact that there is no public market for FLP interests. Partnership agreements almost always restrict sales to outsiders, making the interest highly illiquid. This discount can range from 10% to 35%.

When combined, these discounts can reduce the taxable value of a gifted interest by 20% to 50%. If you gift an LP interest that corresponds to $1 million of CRE, a 35% combined discount means you report a gift of only $650,000 to the IRS. You have successfully transferred the full $1 million of wealth while only using $650,000 of your lifetime gift tax exemption.

The Critical Trade-Off: Estate Tax Savings vs. Future Capital Gains

Understanding tax basis is crucial to grasping the strategic choice you must make with an FLP.

Gifting During Life (Carryover Basis): When you gift an LP interest to your child, they also inherit your original cost basis in the underlying property. If you bought a building for $200,000 and it’s now worth $2 million, your child receives your low $200,000 basis. If the FLP sells that building, your child will have to pay capital gains tax on their share of the $1.8 million gain.
Inheriting at Death (Step-Up in Basis): Assets you own at the time of your death receive a “step-up in basis” to their fair market value on your date of death. If you held that same building until you passed away, your child would inherit it with a new basis of $2 million, effectively erasing the $1.8 million capital gain for tax purposes.

This creates a direct conflict. Gifting LP interests is fantastic for avoiding the 40% estate tax but preserves a future capital gains tax liability for your heirs. Holding the assets until death eliminates the capital gains tax but exposes their full, undiscounted value to the estate tax. The right choice depends entirely on your family’s net worth, the appreciation of your assets, and your long-term goals.

Real-World Scenarios: How an FLP Plays Out

To see how these rules work in practice, let’s explore the three most common situations CRE investors face with an FLP.

Scenario 1: The Successful Generational Wealth Transfer

The Martinez family owns a $20 million portfolio of commercial properties. Their goal is to transfer wealth to their three children while minimizing estate taxes and retaining control. They work with an experienced attorney and CPA to execute a flawless FLP strategy.

Gifting Action	Tax Consequence
Formation & Funding: The parents form “Martinez Properties, FLP” and transfer $15 million of CRE into it. They act as 1% General Partners and initially hold the 99% Limited Partner interest. They keep $5 million in personal assets outside the FLP for living expenses.[1]	This is a non-taxable event. By retaining sufficient outside assets, they create a strong defense against a potential IRS claim that they have an “implied right” to use FLP funds for personal needs.[1]
Valuation: They hire a qualified, independent appraiser who determines a defensible combined valuation discount of 35% for the LP interests.[1]	The $14.85 million in LP interests is now valued at only $9.65 million for gift tax purposes. This immediately removes over $5.2 million of value from their taxable estate.[1]
Systematic Gifting: Over several years, they gift LP interests to their children, using their annual gift tax exclusions and a portion of their lifetime exemptions.[1]	They successfully transfer the entire $15 million portfolio to their children while only reporting gifts valued at $9.75 million. This results in over *$2.1 million in direct estate tax savings* (40% of the $5.25M discount).[1]

Export to Sheets

Scenario 2: The Creditor Attack on a Limited Partner

One of the Martinez children, a limited partner, is involved in a serious car accident and is sued for $2 million, far exceeding their insurance coverage. The creditor obtains a judgment and attempts to seize the child’s assets, including their interest in the family’s valuable CRE portfolio held by the FLP.

Creditor’s Action	FLP’s Protection
Attempt to Seize Property: The creditor’s attorney tries to force the FLP to sell one of its commercial buildings to satisfy the judgment against the child.	The court denies this request. The building is owned by the partnership, not the individual child. A creditor of a limited partner cannot seize partnership assets.[7, 10, 2]
Obtain a “Charging Order”: The creditor’s only legal remedy is to get a charging order against the child’s LP interest.[10, 2]	This order only gives the creditor the right to receive any cash distributions if and when they are made to that child. It grants the creditor no voting rights and no say in management.[2]
Wait for a Payout: The creditor now holds a right to a potential future payment that may never come.	Mr. and Mrs. Martinez, as the General Partners with sole discretion over distributions, choose to withhold them. The creditor is left with a worthless judgment, often forcing them to settle for a tiny fraction of the original amount.

Scenario 3: The IRS Audit Failure

The Williams family hears about FLPs from a friend and decides to create one themselves to save on taxes. They are in their late 70s and in declining health. They make several critical errors that attract an IRS audit after Mr. Williams passes away.

Family’s Mistake	IRS Consequence (Based on Real Court Cases)
“Deathbed” Planning: They form and fund the FLP just three months before Mr. Williams’s death.	The IRS argues, and the Tax Court agrees, that the FLP lacks a legitimate non-tax business purpose. It is viewed as a testamentary transfer designed solely to avoid estate tax, violating the “bona fide sale” exception of IRC § 2036 (Estate of Erickson).[15]
Commingling Funds: They transfer nearly all their assets, including their personal residence, into the FLP. They continue to pay personal bills, like credit cards and property taxes on their home, directly from the FLP’s bank account.	This is fatal. The court finds an “implied agreement” that Mr. Williams retained the personal enjoyment of the assets. The assets were merely “recycled” into a new form of ownership without any real change, triggering IRC § 2036(a)(1) (Estate of Thompson).
Ignoring Formalities: They never hold formal partnership meetings, fail to keep minutes, and make disproportionate distributions to themselves when they need cash, rather than pro-rata to all partners.	The court rules that the partnership was not operated as a legitimate business entity. The FLP is disregarded for tax purposes, and the full, undiscounted value of all the CRE assets is pulled back into Mr. Williams’s taxable estate.[14, 17]

The Operational Playbook: A Step-by-Step Guide to a Bulletproof FLP

Creating an FLP that can withstand IRS scrutiny is not a DIY project. It requires a team of professionals and meticulous attention to detail. The process is formal and must be treated with the seriousness of launching a real business.

Step 1: Assemble Your Professional Team

Before you do anything else, you must hire a team of experienced advisors. This team is non-negotiable and should include:

An Estate Planning Attorney with deep expertise in FLPs.
A Certified Public Accountant (CPA) to handle the complex tax filings.
A Qualified Financial Advisor to ensure the strategy aligns with your overall financial goals.
A Qualified and Independent Appraiser to produce defensible valuation reports.

Step 2: Draft a Robust Partnership Agreement

The partnership agreement is the constitution of your FLP. It is the primary document the IRS and courts will examine. It must be professionally drafted and customized to your family’s specific situation, clearly defining every aspect of the partnership’s operation.

A strong agreement for a CRE portfolio will meticulously detail the following:

Partner Roles and Ownership: Clearly identifies who the General and Limited Partners are and their exact ownership percentages.
Management Authority: Explicitly grants the GP sole authority over all management decisions related to the properties, including leasing, sales, financing, and maintenance.
Capital Contributions: Lists the exact assets contributed by each partner and establishes their initial capital accounts.
Distributions: Outlines the rules for distributing income and profits. It must state that all distributions will be made on a pro-rata basis according to ownership percentages.
Transfer Restrictions: Includes strict limitations on the ability of LPs to sell or transfer their interests to anyone outside the family. This is crucial for justifying the lack of marketability discount.
Buy-Sell Provisions: This is a critical clause that dictates what happens if a partner dies, becomes disabled, gets divorced, or declares bankruptcy. It typically gives the other partners or the partnership itself the right of first refusal to buy the interest, preventing it from passing to an ex-spouse or creditor.
Dissolution: Specifies the exact conditions and voting requirements needed to dissolve the partnership.

Step 3: Formal Creation and Funding

Once the agreement is drafted and signed, you must take the formal steps to bring the entity to life and fund it with your CRE assets.

File with the State: Your attorney will file a Certificate of Limited Partnership with the appropriate state authority.
Obtain a Federal EIN: The partnership needs its own Employer Identification Number from the IRS for tax purposes.
Open a Separate Bank Account: The FLP must have its own, dedicated bank account. This is an absolute requirement.
Formally Transfer Title: This is one of the most commonly missed steps. You must execute and record new deeds for every single property, transferring legal title from your name to the name of the partnership. The property is no longer yours; it belongs to the FLP.

Do’s and Don’ts of Operating Your FLP

Creating the FLP is only half the battle. Operating it correctly is what ensures its long-term success and validity.

Do’s (The Right Way)	Don’ts (The Wrong Way)
✅ Maintain Separate Finances: All partnership income goes into the FLP account, and all partnership expenses are paid from it.	❌ Commingle Funds: Never pay for personal expenses like groceries, vacations, or your home’s utility bills from the FLP account.
✅ Hold Annual Meetings: Hold formal meetings with all partners at least once a year and keep detailed, written minutes of what was discussed and decided.[7, 2, 14]	❌ Act Unilaterally: Do not treat the FLP assets as your personal piggy bank. All major decisions should be documented as partnership actions.[21, 20]
✅ Make Pro-Rata Distributions: If you decide to distribute profits, every partner must receive their exact proportional share based on their ownership percentage.[14]	❌ Make Disproportionate Distributions: Never give a special distribution to yourself or one child to cover personal expenses. This is a massive red flag for the IRS.
✅ File Partnership Tax Returns: Your CPA must file a Form 1065 information return for the partnership each year and provide a Schedule K-1 to each partner.[2]	❌ Ignore Tax Filings: Failing to file the required tax forms signals to the IRS that you are not treating the FLP as a legitimate entity.
✅ Retain Sufficient Personal Assets: Keep enough assets outside the FLP to comfortably cover all your living expenses for the rest of your life.[1, 21, 20]	❌ Transfer Everything You Own: Putting all your assets, especially your personal residence, into the FLP is seen as proof of an “implied agreement” to retain personal use.[21, 20]

Key Court Rulings: Learning from Others’ Mistakes

The IRS has successfully challenged and invalidated many FLPs in Tax Court. These cases provide a clear roadmap of what not to do.

Estate of Thompson: This case established the danger of the “implied agreement.” Mr. Thompson transferred most of his assets to his FLP and then continued to have the FLP pay for his personal expenses and annual family gifts. The court ruled he retained the “possession or enjoyment” of the assets, pulling their full value back into his estate under IRC § 2036(a)(1).
Estate of Powell: This ruling was a shock to many because it applied IRC § 2036 to a decedent who was only a limited partner. Because the partnership agreement gave her the power to join with the other partners to dissolve the FLP, the court found she retained the right “to designate the persons who shall possess or enjoy the property,” which was enough to invalidate the plan.
Estate of Fields: This recent case reinforced the critical error of “over-funding.” The decedent transferred so many assets into the FLP that not enough was left outside to pay the anticipated estate tax liability. The court saw this as clear evidence that there was an implied agreement that the FLP’s assets would be used to satisfy the decedent’s personal obligations.

Strategic Alternatives: Is an FLP Always the Best Choice?

While powerful, the FLP is not the only tool available. Depending on your primary goal—be it tax reduction, asset protection, or simple management—other structures might be a better fit.

FLP vs. Limited Liability Company (LLC)

The LLC is a popular alternative, but it has key differences that make it better for some goals and worse for others.

Liability Protection: This is the biggest distinction. An LLC provides limited liability protection to all of its members. In an FLP, the General Partner has unlimited personal liability. For pure liability protection, the LLC is superior. A common advanced strategy is to form an LLC to serve as the General Partner of the FLP, shielding the individual family members from liability.
Control and Estate Planning: The rigid GP/LP structure of an FLP is specifically designed to concentrate control with the senior generation and maximize valuation discounts for estate planning. An LLC is more flexible but may not support the same level of discounts, as the legal lines between control and passive ownership can be less distinct.

When a Trust is a Better Option

Trusts serve different purposes and can offer even stronger protection in certain scenarios.

Irrevocable Trusts: If your absolute top priority is removing assets from your estate and protecting them from all future creditors, an irrevocable trust is more powerful. When you transfer assets to an irrevocable trust, you give up all control to an independent trustee. This complete surrender of control is what provides the ironclad asset protection, as creditors cannot touch assets you no longer legally own or control.
Offshore Asset Protection Trusts: For the highest possible level of asset protection, specialized trusts in jurisdictions like the Cook Islands or Nevis are unmatched. These trusts are designed to be impenetrable to U.S. court orders, making it practically impossible for a creditor to reach the assets. They are complex and expensive but offer the ultimate defense.

Comparison of Wealth Protection Structures

Frequently Asked Questions (FAQs)

Can I put my personal home in an FLP? No. Transferring personal-use assets like your primary residence into an FLP is a major red flag for the IRS. It undermines the required business purpose and can cause the entire structure to be invalidated.
Who is the ideal candidate for an FLP? Yes. The ideal candidate is a family with a net worth well above the federal estate tax exemption, holding income-producing assets like CRE, and having a clear non-tax goal like centralized management or succession planning.
What are the typical setup costs? Yes. Setting up an FLP is expensive. Initial legal, accounting, and appraisal fees typically range from $8,000 to $15,000 or more, with additional ongoing annual costs for tax preparation and maintenance.
Can I just create an FLP when I get old or sick? No. This is called “deathbed planning” and is one of the fastest ways to have an FLP invalidated by the Tax Court. The partnership must be established well in advance of any health issues.
Do I still need insurance if I have an FLP? Yes. An FLP is not a substitute for proper liability and umbrella insurance. Insurance is your first line of defense against lawsuits; the FLP provides a powerful second layer of protection for your assets.
Can an FLP help me avoid probate? Yes. Assets titled in the name of the FLP are owned by the partnership, not you personally. Therefore, they are not subject to the probate process in your will, which can save time and money.
What happens if a child with an LP interest gets divorced? Yes, a well-drafted partnership agreement protects against this. It can include buy-sell provisions that prevent an ex-spouse from becoming a partner, often giving the family the right to buy out the interest.