Before putting a rental property in an LLC to minimize taxes, be sure you can depreciate the building to reduce your tax liability.
Q: I recently inherited a rental property. The property is rented and cash flow is positive, despite the fact that there is a mortgage on the property. Currently, I do not need the income that the property is generating. I am more interested in keeping my tax liability low.
Can I put the property into an LLC and count 100 percent of the mortgage as business expense?
A: You might want to talk to a tax accountant or advisor so that he or she can put these questions into context for you, but we’ll take a crack at walking through some of these issues.
It seems to us that your question isn’t really about how you hold the rental property but rather what that income does to your income taxes. Have you considered that the property you inherited will be depreciated over time and that depreciation will ultimately reduce your federal income tax liability?
While your property costs may be less than the income you receive, we wouldn’t be surprised if the property’s depreciation would actually create a loss on your tax return. Depending on your income level, you may be able to take some of that loss each year and reduce your overall tax liabilities.
Putting the rental property into a limited liability company (LLC) will cause other headaches. You will have the added expense of setting up the company and paying the annual fees to the Secretary of State where it is set up. You may also have additional accounting expenses and have other costs related to the LLC and the state in which the property is located. And, if you are the only member of the LLC, you might have created an entity that for federal income tax purposes would be disregarded and included in your tax return anyway. Also, since there is a mortgage on the property, your lender might call the loan, forcing you to go through the added work of refinancing.
We’d want you to look at your situation from various perspectives. First, ask what it will cost you to set up and maintain the LLC. Second, try to understand what unintended consequences you create by placing the property in an LLC. Third, decide if you benefit from personal liability by holding the property in an LLC. Finally, try to get a handle on the tax consequences of placing the property into the LLC.
With respect to the first question, you can research the cost of setting up an LLC in your state by going online to your secretary of state’s website. You’ll find out what it costs to organize the LLC and what the annual fee to keep it in good standing will be. Along those lines, you’ll also have to find out what it will cost you to transfer the title of the property from your name to the name of the LLC.
On the second issue, some states have higher real estate taxes when a property is transferred or sold. While an inheritance may or may not trigger those higher sales, the transfer of a property from an individual to an LLC might. Some states also charge a tax on LLC’s based on the revenue they receive. While you might then save some money at the federal level, you might end up paying more money to your state. If you must file a tax return for the LLC and you can’t fill it out yourself but will have to hire an accountant, you should consider that expense too.
If you’ll end up paying $500 more in federal income taxes per year because of the income generated by the property but will end up paying $1,500 more in fees if you create an LLC, you might be better off keeping the property in your name. Also, consider that you have a mortgage on the property and your lender may treat the transfer of the property into an LLC as a sale and can call the loan due. Once the property is in an LLC, most residential lenders won’t touch it. You’d have to refinance the property through a commercial lender, paying higher fees and a higher interest rate.
Next, is there a benefit you’ll receive by using an LLC to protect your other personal assets? While most commercial real estate developers and owners use LLCs for their real estate holdings, many individuals may not get the full benefit of the LLC protections if they personally perform management services and repairs at their properties. For many of the liability issues, you might consider a good insurance policy with high limit umbrella coverage.
Most high liability issues relating to a building will have to do with a personal injury case. You’ll need insurance anyway so why not spend a bit more to make sure that you have a really good insurance company (with a great claims-paying history) with extensive coverage over the issues that could cause you harm?
Finally, we’re going to wind up where we started, and recommend that you’ll need to research your own tax issues thoroughly and sit down with someone who will walk you through your federal and state income tax liabilities.
If you received the “stepped up” basis for the property, you effectively can claim that the basis for the property is its value at the time you inherited the property. If the property has a high value, you’ll get the opportunity to depreciate the building on the property over 27.5 years (in most common cases) and reduce your tax liability accordingly.
The tax specialist may have other advice for you on how to minimize your taxes, if that’s the highest priority.