The Real Deal on Investment Real Estate and LLCs
Did you know that you can better protect your investment in real property by forming and transferring ownership to a limited liability company? If you are one of the many investors in real estate you should consider holding your investment property in a limited liability company (LLC) rather than personally. The benefits of holding title to investment property in an LLC include limited liability protection, pass-through tax treatment of profits and losses, and the ability to transfer property in and out of an LLC with minimal tax consequences.
The liability protection of an LLC is one of the simplest and most cost effective methods of protecting and separating your investment property from your other assets. An LLC is a hybrid entity, combining some of the advantages of both partnerships and corporations. LLCs provide owners with the liability protection typically associated with corporations and the tax benefits and flexibility of partnerships. One of the biggest advantages of an LLC is that the owners (called members) and their personal assets are generally protected against liabilities and obligations of the LLC. LLC members may include individuals, partnerships, LLCs, or corporations, and LLCs have no limitation on the number of members they may have. The benefits of an LLC include pass-through tax treatment (the profits and losses are reported and taxed on each member’s individual income tax return rather than at the entity and individual level). Additionally, an LLC’s allocation of profits and losses does not have to be distributed according to ownership percentage if the operating agreement provides otherwise which provides flexibility for different kinds of members.
LLCs are the preferred entity for ownership of investment real estate. For LLCs, there is generally no tax liability incurred on contributing assets into or distributing assets out of the LLC to the members. This flexibility is one of the primary reasons an LLC is the favored entity for holding title to investment real estate. Corporations are generally disfavored for holding title to investment real estate because the property cannot be distributed out of the corporation without triggering a taxable event. Holding investment real estate as an individual or general partnership does not provide limited liability protection.
How do I form an LLC? There are a number of formalities that generally must be complied with in order to properly form, organize, and maintain an LLC. The LLC must have articles of organization, and should have an operating agreement (an agreement among the members), be adequately capitalized, have a separate bank account, enter into all contracts and leases in the name of the LLC, and obtain insurance that specifically covers the LLC, just to name a few. The operating agreement is particularly important if the property is owned by multiple investors (to provide for operational governance and buy/sell provisions), or if you plan to allocate profit and losses other than by ownership percentage.
If I already own real property how do I transfer it into an LLC? When possible, it is preferable to initially purchase property in the name of an LLC rather than transferring it into the LLC. If the purchase has already occurred, technically, all that is necessary is an executed and recorded deed conveying the property from the existing owner(s) to the LLC. We recommend that you consult with a lawyer prior to any transfer of property to ensure that it is done properly and all risks are understood.
Some other issues you need to consider if you decide to transfer your real property to an LLC.
• Financing. Most financing arrangements have a “Due on Sale” provision which allows a lender to demand payment on a debt if the property is transferred from the original borrower. An owner should consider obtaining written approval from their lender prior to transferring title into an LLC.
• Transfer Taxes. Transfer taxes may apply to the transfer of the property into an LLC, depending on local law. The conveyance may also trigger an adjustment to your property taxes.
• Insurance. Title insurance policies typically define the “insured” and this definition often does not include a transferred interest into an LLC. Prior to transferring the property, you should consider either obtaining a new title insurance policy or obtaining an endorsement for the LLC if possible.
• Exit Strategy. Often
investors in real property desire to take advantage of 1031
Tax-Deferred Exchange rules. There are many limitations
with 1031 Tax-Deferred Exchanges, including that the party that
sells the property must also purchase the replacement
property.
Prior to structuring a formation or transaction you should consult tax and legal professionals to ensure proper structuring.
Heather Hepburn practices in the business services group at Karnopp Petersen LLP. Her practice includes real estate transactions, general business advice, business sales and acquisitions, and finance and securities. Heather can be reached at 382-3011 or hjh@karnopp.com.
This article is for informational purposes only and does not constitute tax or legal advice.