Q: I currently own a rental property without any mortgage. I have lived in the house as my primary residence for three years before renting it out so I am assuming that I will not have to pay capital gains taxes when I sell it. The title is currently in my name and I want to transfer it to an LLC to protect myself.
Are there any tax implications to transferring it to the LLC? If and when the LLC sells the property, will the LLC incur capital gains tax?
A: There are several parts to your question. The first part addresses the issue of paying capital gains taxes on your primary residence. If you have lived in your home for two out of the last five years, you don’t have to pay federal income taxes on any gain from the sale if the gain is less than $250,000, if you’re not married, or $500,000 if you are married.
That’s the good news. Now if you rent the home for part of that time, as you have done, you may have to pay taxes when you sell that property. The taxes you might have to pay would involve the recapture of any benefits you took while the home was rented. If you rent the home for two years and take depreciation benefits on your tax returns for those years, when you sell the home you may have to pay taxes back to the government in the form of a recapture tax.
In addition, starting with home sales after January 1, 2009, you also will have to pay capital gains tax on part of the sale. To compute the amount you might owe in capital gains you would have to determine the length of time you owned the property and the length of time the property was rented. If you lived in your home as a primary residence for 12 years, and rented it out for one year, you’d pay capital gains tax on 1/13 of the profit.
The IRS will ignore certain types of ownership interests in determining whether your home is owned by you and is your primary residence. For example, if you put your home into a living trust for estate planning purposes, the IRS will ignore the living trust and treat the home as yours.
When you transfer title of the home to an LLC, you may face various issues, including:
• Is your home still your personal residence? Depending on the state in which you live, your home may no longer be considered your personal residence. Will this be a problem for the IRS?
• Will transferring title to an LLC cause a taxable event for the IRS? The transfer of the home into an LLC may be a taxable event for federal income tax purposes and therefore, when the LLC sells the home in the future, the LLC will not benefit from the tax exclusion given to individuals.
• You may owe other sorts of taxes. In some states, homes that are owned by corporations or limited liability companies no longer enjoy the tax benefits that other homes owned by individuals would have, like a homeownership exemption.
• Your property taxes may be reassessed. In some states, the transfer of the home from your name to the LLC will trigger a reassessment for real estate tax purposes and can significantly increase your annual real estate tax bills.
• Who or what who are you trying to protect? If you’re trying to protect your personal assets from creditors, you’d only be protecting yourself if it’s related to the home while it is owned by the LLC. Any litigation involving you personally will subject the LLC and your personal assets at risk. If you’re trying to protect yourself in your dealings with your tenant, your biggest risk involves the leasing arrangement. You need a good lease document that complies with all municipal requirements in your area. Don’t use a form that you might find on the Internet unless that form is specifically tailored to your area. Some municipalities have specific requirements for their leases and if you violate those terms, you might give the tenant the right to terminate the lease or sue you for damages.
• Make sure you have the right insurance. A landlord’s risk is greater that something should injure or harm a person at the property and the landlord would have some responsibility. For that risk, a landlord should have good insurance coverage. Most insurance coverages for landlords will have liability coverage of at least $1 million dollars and for a bit more a landlord can buy $2 to $5 million dollars of liability coverage. A small landlord that takes care of his or her own maintenance might subject himself or herself to personal liability if he or she fixes something and later someone is hurt. Even if the property was in an LLC, an owner might be subject to liability if he or she is directly involved in the management of the property.
• Owning property in an LLC carries additional expenses. You’ll have expenses associated with creating the LLC, maintaining the LLC on a year to year basis, and additional expenses associated with the tax returns that you might have to prepare for the LLC. For property owners who have many real estate holdings, and management companies that take care of these properties, these expenses might be worth it. For others, particularly owners of one or two real estate properties, these people might benefit more by using the money they save due to the LLC expenses to obtain more and better insurance coverage for their properties and themselves.
• Financing property in an LLC can more difficult. While you don’t have a mortgage on your property now, you may well want to take out a mortgage in the future. It has been increasingly difficult for property owners to finance second homes and other investment real estate during the credit crisis, although financing is available. Once you transfer the property to an LLC, the availability of financing options will be reduced and you will find that lenders will only finance the LLC property at higher interest rates with substantial fees. In some cases, you’ll find that lenders will actually advise you to take the property out of the LLC to obtain lower interest rates.
All in all, before you decide to put the property into an LLC weigh all of the benefits of the LLC, the costs associated with the LLC and then weight the benefits of keeping the property in your name along with the costs of keeping it in your name.
And be sure to consult a real estate attorney who can walk you through the specifics of your own deal.
May 7, 2009