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Planning with Real Estate in LLCs

Insights Financial Planning Taxes

If you own real estate, beyond a primary residence and perhaps a vacation or second home, you probably have heard about and possibly been advised to own that real estate inside a limited liability company (LLC). An important advantage of an LLC is the protection it provides in terms of personal liability. When a property is owned by an LLC, potential liability for claims arising in connection with the property is limited to the LLC and typically won’t extend to the persons owning the LLC. In the context of real estate, this protection can be valuable as protection against claims by renters, business invitees on the premises, even trespassers injured on the property. Another advantage is the relative privacy that the LLC offers to the members since it is the LLC, and not its owners, that is who or what is public. 

The LLC is an entity which pays a fee to become registered with the state and often will also pay a small annual fee for renewal of the registration. Some states also require the payment of a franchise tax which may become onerous so a review of the applicable state requirements is important before settling on an LLC. The costs for setting up an LLC typically are reasonable (varies greatly from state to state), though it will be important to consult with your attorney on the details of the operating agreement to ensure the entity will function as you intend. 

An operating agreement sets forth the terms and requirements of the LLC, including identification of its members, their rights as to the assets and income of the LLC and how and by whom the day to day business will be conducted. Ordinarily, the general partner is the member who will be handling the business of the LLC while limited partners will not play an active role in the operation. One person may hold both general and limited partner interests in the LLC and a single member LLC allows one individual to be the only member. Since the LLC is a pass-through entity, the income tax effects will flow through to the members with income being taxed at each member’s individual rates and brackets. 

Property Held in the LLC

Where real property is to be the primary asset in an LLC, there are a number of considerations which will help you decide if an LLC is the best approach. A first caution: an LLC is rarely the right choice for your primary home or residence. This is because, among other things, there are legal protections for a your home that are not available for rental property; financing for your personal residence is likely to be easier and cheaper to obtain than that available for a rental; tax consequences for home ownership are very beneficial and much different than those associated with rental property; and so on. 

Perhaps the first question to address is whether a new property is to be acquired after the LLC is formed or if a property already owned by the prospective owners of the LCC is to be transferred to the LLC. Where the property is owned by the person forming the LLC, then it will be necessary for the owner to transfer the title of the property to the LLC and not remain as the individual owner. It would defeat the purpose of the LLC – limited liability – if the owner retained title. 

In such case it is likely that there will be liability insurance already covering the property before its transfer.  Depending on the terms of the existing policy, the insurer’s own rules and your state’s regulations for insurance companies, it might be necessary to acquire a new and different (and possibly more expensive) policy naming the LLC as the insured. Be sure to make inquiry before committing to a transfer of property you already own. 

Another possible issue arises where there is an existing mortgage on the property, since the transfer of the property to a new entity – the LLC – may trigger a due on sale clause or cause a review of the loan and raise the chance it will be called by the lender. It is better practice to contact the mortgage lender before transferring the property to make sure that things will transition smoothly. 

The good news is that where the property is acquired by the LLC from another source, then the title, the mortgage and the insurance will all be under the LLC from the beginning and these issues are no longer a concern. Of course, as noted above, financing through an LLC may be more expensive and time consuming than financing your own home. In some cases, a personal guarantee will be required of the owner(s) in order to secure that financing. 

Out of State or Multistate Properties

Another area of concern relates to the location of the property to be placed in an LLC. Is the real property located in the same state as the state where the LLC was formed?. Since an LLC often may be able to own real property in more than one state, this is not an uncommon issue. However, where the property is in business use, even as limited as a residential rental, it may be necessary for the LLC to register as doing business in that other state where the property is located, name an in-state representative to receive service of process and to pay any required fees to the state as well. An alternative approach is to form the LLC in the state where the real property is located even when the owners reside outside the state. That will simplify the process somewhat as the LLC will be registered in and paying fees to only one state.

Holding income producing property in another state can complicate the owner’s income tax situation since income earned by the LLC in another state is likely to be taxed there which may also require an additional filing with that state as well as the need to seek a tax credit in the owner’s home state since income is passed through to the owner.  

Some advisors (accountants, attorneys, realtors, etc.) will suggest that you create separate LLCs for each rental or business property. The primary reason is not to obtain extra fees but, rather, to isolate each property so that liability claims which involve one property do not cause other properties to become subject to those claims, thus providing the liability protection which is often the basis for choosing the LLC in the first place. 

Other Benefits

Incidentally, holding property in an LLC is also a useful planning tool for the owner’s estate. The LLC format allows one to gift limited partner interests without giving up control and to choose where, ultimately, the general partner interest will pass. The LLC entity also may provide additional credibility for your business to prospective clients, contractors, investors and more. Your advisor, attorney and/or accountant can help you make the right decision.  

George Chamberlin & Mentor RIA Consulting © 2018-9

(804) 591-1657