Generally, most individuals purchase real estate personally. This means that the deed to the property names the individual as owner. It is increasingly common for individuals to purchase through a holding entity, such as an LLC. The individual owns the LLC and the real estate is held in the name of the LLC.
There are a number of considerations when determining whether to hold the property individually or as an LLC. In this article we review some of those considerations.
If two or more individuals wish to own property together, there are really two options. Those individuals can list all of their names on the deed as tenants in common or joint tenants. Tenancies in common allows for an equitable division of the property interests. Joint tenancy means the interests of each partner is not divisible. Each owner owns a percentage of the land. If any owner leaves or passes away, the other owners acquire that partner’s ownership. The downside of holding property in this manner is that it can be difficult to transfer ownership in the property. This is particularly true for property held as joint tenants.
Using an LLC can make transferring ownership of the property easier. When the LLC owns the property, the owners of the LLC hold a percentage interest of membership units of the LLC. These individuals can transfer all or some of their ownership in the property by transferring or selling their ownership interest. This arrangement is particularly useful when one of the LLC owners slowly acquires a greater ownership interest in exchange for work done or services supporting the LLC or underlying property.
If individuals purchase property in their own names, any lending institution extending a loan and taking a mortgage in the property will charge a rate of interest on the loan. The rate will be determined by the personal credit ratings (and other asset and income considerations) of the individual owners. If the individuals purchase the property as an LLC, they must generally seek a business (rather than personal) loan. The rate of interest will depend upon the value of the property and the credit ratings of the LLC owners (who will have to co-sign, guaranteeing personal payment of the loan). Because the loan will be classified as a business loan, the rate of interest is generally considerably higher than a commensurate personal loan.
Individuals holding real estate that they live in for two years receive a major tax benefit. If those individuals later sells the property, the Internal Revenue Service allows for a $250K dollar tax exemption for capital gains realized when the property is later sold. Assume the property is purchased for $100K and later (after two years living in the property) it is sold for $350K. The $250K of capital gains would not be taxable to the owners.
There are numerous tax benefits associated with holding the property as an LLC as well. If the property is held in the name of the LLC, it is considered a business asset. Any expenses associated with owning and maintaining the real estate may be treated as a business expense. Examples of common expenses include maintenance (such as yard maintenance) and equipment upgrades (such as HVAC units).
Further, the LLC may qualify for preferable tax status if the property held produces income. An LLC may qualify to elect S-Corporation tax status. As of 2018, S-Corporations are afforded a 20% deduction for recognized income for income tax purposes. Further, any income from the property is generally exempt from Federal Insurance Corporation Act (FICA) taxes. This combination can provide considerable income tax benefits.
Personal Liability Protection
Individuals who own property in their own names are subject to personal liability for any debts or obligations arising out of owning the property. This could come about if someone is injured on the property or the property becomes subject to costly environmental cleanup requirements.
Holding real estate in an LLC can shield the owners of the LLC from personal liability for any debts and obligations arising from the property. Of course, any creditor can sue the LLC for any assets held by the LLC (including the underlying property). If the value of LLC assets is not adequate to pay the judgment, the individual cannot seek to recover against the personal assets of the LLC owners. The LLC members must adhere to numerous formalities to maintain the LLC interests. These formalities include adequately funding the LLC for operations, maintaining separation between personal and assets. The LLC owners should also maintain appropriate liability insurance for accidents occurring on the property.
The above-referenced benefits associated with holding real estate personally or as an LLC. There may be numerous other advantageous that employ business entities to structure more favorable ownership and tax scenarios for the individuals carrying out transactions with real estate. If you are considering holding real estate for business purposes, first talk with our legal professionals who can assist you with business formation.