Forming an LLC (a Limited Liability Company) to hold real estate has long been a common approach for estate planning, tax, liability and privacy concerns. While this practice is perfectly legal in California and elsewhere, there are some considerations and tax implications. High-end properties, especially those purchased in all-cash transactions, such as many homes in Newport Beach, Laguna Beach and Coastal Orange County, are frequently purchased and held in LLCs. Regardless if your portfolio consist of large commercial properties, or a single rental condo, an LLC may be right for you.
Let’s look at some of the advantages:
– Privacy. An LLC adds an extra layer of privacy for any buyers that might not want their name to appear in countless public databases, where anyone can find out where they live. Celebrities and high net worth individuals may have legitimate security and other concerns accompanying the desire for privacy. However, there still must be initial and annual filings with the Secretary of State that do require listing the LLC’s Management. Some buyers may trust their attorney or other individual(s) to act in this capacity, thereby keeping their names completely off the LLC filings; however, some may want to ensure they are listed on those initial documents to reduce the risk of any fraud or embezzlement.
– Liability. Landlords and investors, this is for you. All landlords should know the inherent risks of rental property ownership: from simple repairs, to a catastrophic “slip and fall” on the property, there is grave risk, potentially exceeding the value of the property. Ideally, every landlord already has ample insurance for any such losses (at least $1 million, or much more). But that may not be enough. If someone is seriously injured on the property and obtains a $5 million award; your average $1 million insurance policy will be exhausted, leaving your entire assets as open targets for collection. However, if the property is in an LLC, then the liability will be limited to the LLC’s insurance and assets, i.e. the property. If the property is worth $1 million, that $5 million award will get the insurance money and likely get the property, but it will end there, with no liability for the remaining $3 million award against you personally (and/or your other assets).
For this reason, it’s not enough to have one corporation or one LLC hold all your property – each property should be its own LLC to ensure each property’s maximum liability is that property and its insurance coverage, not your other assets. As that gets more complex (i.e. apartment buildings or large portfolios), often a Corporation is formed to then own and manage the LLCs.
Similar protections exist if, for example, multiple individuals own the property and one co-owner has a judgment against them; a well drafted LLC Operating Agreement may protect the entire LLC from a judgment creditor against just one co-owner, limiting the judgment creditor to that co-owner’s distributions, if any.
– Taxes. One will need to consult with their tax advisor regarding the full implication this may have on one’s portfolio. Generally speaking, there is a minimum tax from the State of California (currently $800). But that is often a small consideration for the benefits of an LLC, including pass-through taxation similar to a sole-proprietorship or partnership. This means that owners of the LLC report their share of the income or losses on their individual tax returns. Because of the pass-through tax treatment offered to the LLC, the LLC gets the best of both worlds: the benefit of protection from personal liability; and the tax benefit of being treated like a partnership or sole proprietorship.
For a personal residence in a single member LLC (SMLLC), you can still claim the (current) IRS Section 121 capital gain exclusion of $250,000 ($500,000 if you are married) when you sell your primary residence. California recognizes married couples as one owner that can elect to be treated as an SMLLC.
– Estate Planning. Properties held in LLCs can easily become part of an estate plan. Most owners will opt for an LLC because of the tax and liability benefits; but it can also simplify an estate plan. It can also make it easier to “gift” partial ownership in the LLC (i.e. the property) as you age, within the IRS gift limitations, to reduce the size of your estate at death.
Let’s look at some of the downsides:
– If there is a mortgage on your property, you likely cannot transfer the property into an LLC without risking the “due on sale clause” of your mortgage. Most lenders want the property held by an individual or a trust, not an LLC (for the precise opposite reasons you may want an LLC). If you have a mortgage, read it and check with your lender before executing any transfer. Thus, an LLC may only be available to cash buyers or those who have paid off their mortgage. Other forms of liability protection (such as dramatic over-insurance) should be looked into.
– Any Co-Ownership of any property, LLC or not, must have a well-drafted Ownership Agreement (or LLC Operating Agreement) to clearly set out each parties’ ownership and responsibilities. Thus, there is certainly some costs to form and maintain a proper LLC. However, as noted above, those costs are typically minimal and well worth the benefits.
IRS Section 121: https://www.law.cornell.edu/cfr/text/26/1.121-1
IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this web site is not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed on a taxpayer under the U.S. Internal Revenue Service.
Author Devin R. Lucas is a Real Estate Attorney, Broker and REALTOR®, specializing in Newport Beach, Costa Mesa and Orange County, serving individual, investor and small business interests in real estate. Active with the Newport Beach Association of REALTORS® and Costa Mesa Chamber of Commerce, Devin R. Lucas Real Estate is an independent real estate brokerage and law practice located in Newport Beach, California.
Devin R. Lucas Real Estate
Real Estate Attorney | Real Estate Broker | REALTOR®
devinrlucas.com | firstname.lastname@example.org | BRE No. 01912302
949.478.1623 office | 888.667.6038 fax
2901 West Coast Highway Suite 200
Newport Beach | California | 92663-4023
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