Why Investment Properties (Rentals) Should Be Placed In California LLCs
|Prepared By: Melissa C. Marsh, Los Angeles Real Estate Attorney
Written: February 2005 - Last Updated: February 2017
The California LLC is probably the least understood entity, but it’s the best entity to hold ownership to real estate investment property (rental property) because of the asset protection it provides and the beneficial tax treatment it offers over the corporation.
A California Limited Liability Company Provides Asset Protection.
As most landlords know, there is an inherent risk of liability with property ownership. Some of the risks are foreseeable and can be effectively insured against. Others cannot. Should an accident occur, you might lose not only the property itself, but all of your other personal assets as well. Although insurance can limit your potential exposure, why be exposed at all? The California limited liability company (LLC) offers its member-owners the same limited liability protection offered by the corporation. [California Corp. Code §17101(a)]. Even with adequate insurance coverage, if some negligent act results in severe injury to a tenant, worker, or guest, the resultant award may far exceed the insurance coverage. If the property is held in your personal name, the claimant will be able to attach your personal assets (including other properties, your home, bank accounts, vehicles, stock) to satisfy the judgment. By contrast, if the property is held in a California limited liability company, the LLC may be liable, and its assets subject to attachment by the judgment creditor, but the individual member's personal assets will remain protected.
In addition, a California LLC protects against claims by creditors of the members of the LLC. With a proper LLC Operating Agreement, the creditors of an individual member of the LLC cannot attach the assets owned by the LLC, nor can they step into the shoes of the member. At most, a judgment creditor will be able to place a lien on the distributions from the LLC to the member (if any).
Like a California corporation, a California LLC generally affords its owners with personal liability protection from lawsuits. But the assets within the LLC are not protected from such lawsuits, and creditors of the LLC typically can attach the LLC's assets. Accordingly, despite the additional tax burdens, you should consider placing each of your investment properties into their own separate California LLC.
A California Limited Liability Company Offers Many Tax Advantages.
A California Real Estate LLC can provide significant tax advantages, especially when compared to both a C-corporation and an S-corporation. Like a sole proprietorship or partnership, a California LLC enjoys pass-through taxation. This means that owners (known as "members") report their share of the income or losses on their individual tax returns. Because of the pass-through partnership tax treatment offered to the LLC, the LLC gets the best of both worlds: (1) the benefit of protection from personal liability; and (3) the tax benefit of being treated like a partnership, or sole proprietorship, as the case will be.
A Single-Owner LLC offers an additional unique benefit. Unless the owner of the LLC specifically elects to do otherwise, the IRS will automatically classify a single-owner LLC as a sole proprietor. The owner of the LLC reports the LLC's profits or losses on Schedule C of their personal tax return (usually Form 1040).
In California, spouses who own LLC interests as community property, file joint returns, and are the only members of the LLC, can choose whether the LLC will be treated as a partnership, or as a disregarded entity for income tax purposes (Rev. Proc. 2002-69). If the spouses opt to treat the LLC as a disregarded LLC, it makes it simple to complete a Section 1031 exchanges, as there is no risk that the real estate interests will be reclassified as partnership interests.
A traditional C-corporation is subject to double tax, both at the corporate level and at the personal level. When a C-corporation transfers or sells appreciated real property, the profit (gain) subjects the corporation to a capital gains tax at the corporate rate. Once the capital gains tax had been deducted, the remaining profits if distributed to the corporation's shareholders in the form of dividends, would again be taxed at the capital gains tax rate for individuals (10% to 15%). This is commonly referred to as "double taxation."
Although the S-corporation is similar to a California LLC as far as eliminating the "double taxation" issue, it has other negative tax treatments problems when real estate is involved. If the shareholders of an S- Corporation want to transfer a property held or owned by an S- corporation to another entity, or sell the property in exchange for another property to be held by the S-corporation, the sale or transfer would immediately trigger the 15% capital gains tax on the fair market value of the property minus its original cost. In addition, any losses that may have been realized by the sale are limited to the shareholder’s basis in the S- corporation. And worse, the S- Corporation cannot take advantage of the 1031 Exchange tax treatment. For example, if an S-corporation desires to transfer a property to say a partnership or a LLC so it can be developed, the shareholders of the S-corporation will have to pay income tax on the profit from the alleged sale. By contrast, the transfer or trade of property held by an LLC would be free of such income tax and can result in a tax-free transaction if done properly.
While every California LLC and California corporation must pay the $800 annual franchise tax, most California real estate holding LLCs that hold a single investment property can avoid the gross receipts tax, which does not apply unless the limited liability company's gross receipts equal or exceed $250,000.
The one major negative to the California LLC, which is why a personal home residence should never be placed in a California LLC, is the loss of the federal capital gain exclusion of $250,000 ($500,000 if you are married) on the sale of a personal residence. Pursuant to the 1997 Taxpayer Relief Act, homeowners can lock in a profit of up to $250,000 ($500,000 if married) and owe nothing to the IRS as long as the taxpayer lived in the home as a personal residence for at least 2 of the past 5 years. For more information of this exclusion, see Special IRS Tax Breaks When You Sell Your Home.
Estate Planning Benefits offered by the California Limited Liability Company.
A California LLC also offer unique estate planning benefits for parents wishing to pass ownership of their property to their child(ren). One benefit is the ease of transfer of ownership. The ownership of real estate held by an LLC is represented proportionately by the member's shares in the LLC. Rather than filing a new deed, members can transfer ownership of the property to their children by simply increasing their membership percentage in the LLC.
Best of all, current tax laws allow a tax-free gift of up to $12,000 per year and because the interest transferred from a parent to the child(ren) would be unmarketable minority interests, the IRS will permit up to a 40% valuation discount on the fair market value of the real estate being transferred. In essence, the parents can continue to have control over the property as long as they are the managers of the LLC, and their child(ren) remain merely members of the LLC with a minority interest in the LLC (and in turn the real estate it holds).
For example, let's assume a parent owns a California real estate holding LLC. And let's further assume that the parent has decided to transfer some, or all, of his interest in that real estate holding LLC (and in turn the property) to his two children on a tax-favored basis. Using the annual gift tax exclusion ($12,000 per recipient in 2008), the parent can make annual gifts of interests in the California real estate holding LLC to each of his two children with no transfer tax cost. So the question now becomes, how much of an interest can the parent transfer? Assume the property held by the California LLC is worth $1 million dollars. Applying a valuation discount of 40%, the parent can make a tax-free transfer of $12,000 worth of the property to each child -- which actually represents $20,000 each, or two percent (2%). While you may not be able to transfer the whole of your interest via tax-free gifts, you can significant reduce the size of your estate.
Consider Forming a California Corporation to Manage Your Properties.
If you plan to own, or do own, a very large building with multiple tenants, or multiple rental properties, you should consider setting up a corporation to manage your properties. This will keep your paperwork to a minimum and hopefully substantially reduce the possibility of co-mingling your funds between multiple real estate holding LLCs. For all of the properties you have placed in an LLC, a single corporation can keep the books, pay the bills, arrange for repairs and maintenance, sign leases, etc.
With the benefits of asset protection, tax savings and estate planning aids, the California real estate holding LLC has become the preferred entity for holding individual investment properties. The LLC offers the prized limited liability protection afforded to the corporation, but without the negative tax implications. Before embarking on the formation of a real estate holding LLC, however, you would be wise to speak with an attorney in your local area to discuss the laws in your state, and your particular needs and circumstances.
If you would like to retain the services of Melissa C. Marsh to form and organize a California LLC, please call 818-849-5206 or Send us an Email.
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