Owning Real Estate Through an LLCNovember 15, 2013
Whether for liability protection or privacy reasons, more and more people are inquiring about holding real estate through a limited liability company (“LLC”). Beyond the cost of forming an LLC, there are a myriad of issues associated with putting real property into an LLC, and it is important to consider them all prior to making a decision.
Many well-known or affluent clients favor LLCs because they afford a significant amount of privacy. The only information easily accessible on the California Secretary of State website is the entity name, entity number, date filed, jurisdiction, entity address, the name of the agent for service of process, and the agent’s address. This higher level of privacy is one of the reasons why so many Atherton or Old Palo Alto estate properties are owned by entities like the “123 Pine Street, LLC” rather than by “John and Jane Doe.”
Owning a property through an LLC may provide legal protection from liability for the owner because law suits should be directed towards the LLC as the building owner, and the management company as the property manager, rather than the individuals that happen to own the LLC. However, owners that participate in the operation of the property may find themselves parties to lawsuits for various torts. For example, an owner that fixes a step improperly, or that hires an unqualified contractor, may still be sued personally for their negligence. Thus, an LLC does not protect against all claims against you relating to your property.
“Due-on-Sale or Transfer” Clauses
Deeds of trusts, the instruments that secure notes, commonly contain provisions known as “due-on-sale” or “due-on-transfer” restrictions. These restrictions empower the lender to call the loan due if the title to the property has changed without the lender’s consent. For example, an investor that purchased real estate in his or her own name and later transferred it to an LLC could have their loan called by the lender. That would be bad.
Minimum Franchise Tax
LLCs are generally required to pay a minimum franchise tax of $800, paid annually until the LLC formally dissolves. In addition, this tax is not allowed as a deduction on the California income tax return filed by the LLC or its members. While the franchise tax may be deductible on the federal return as a state income tax, this deduction may be limited by the Alternative Minimum Tax.
Capital Gain Exclusion
If you transfer your primary residence into a multiple-member LLC, you should lose the ability to benefit from the IRS’ capital gain tax exclusion. The capital gain tax exclusion allows you to exclude up to $250,000 (single) or $500,000 (married filing jointly) of capital gain when you sell your primary residence, so long as you’ve lived in and owned your home for at least two of five years. However, if you transfer your primary residence into a single-member LLC you may still take advantage of the capital gain exclusion because the LLC is treated as a “disregarded entity” for federal tax purposes. Further, recent guidance has provided that spouses in community property states, such as California, can be treated as only one member. Thus, married couples may be able to retain some of the tax benefits associated with an individual’s primary residence.
Mortgage Interest Deductions
If you transfer your primary residence to a multiple-member LLC, you may no longer qualify mortgage interest income tax deductions because you no longer own the property individually (so you can’t take the deduction personally). However, in a single-member LLC, the owners are generally entitled to mortgage interest deductions because a single-member LLC is treated as a disregarded entity.
Real Estate Transfer Taxes
In Santa Clara County, if a legal entity that owns real estate undergoes a change in control for property tax purposes, a documentary transfer tax is due. However, any conveyance that “changes the manner in which title is held, grantor(s) and grantee(s) remain the same and continue to hold the same proportionate interest” is exempted from this transfer tax. This exemption includes transfers of real property into an LLC, so long as the same proportionate interest is being transferred.
Forming and maintaining an LLC can be expensive, but some owners may find the combination of enhanced privacy and liability protection make it worthwhile— especially with investment properties. However, taxpayers should thoroughly discuss all of the tax, estate planning, and liability issues with their real estate agent, attorney and/or tax accountant before making any moves. The unanticipated consequences may be more significant than expected.Owning Real Estate Through an LLC