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.
[amazon_link asins=’B00XWDFNXG,B06XCF7QFR,B012HFTK60,B01JJXMULU’ template=’ProductCarousel’ store=’thinkglink-20′ marketplace=’US’ link_id=’a2f22e31-9124-11e7-a781-9b4049bbfee1′]
Just to be clear, if I buy a house at a foreclosure sale in there is also a mortgage lien or any other lien, I’m I responsible for that, or it’s getting wiped out??
Your responsible for any unpaid debt attached to the property such as a mortgage or tax lien
I am confused. When you depreciate the property, it brings down the taxable income and thereby I pay less income tax. However, when I sell, don’t I have to recapture all the depreciation? Won’t this increase my income tax liability (when I sell) that year? Also, doesn’t it put me into a higher AGI for that year, where my medicare premium goes up through the roof? (only for that year) Thanks. I have enjoyed your column all these years…..
Just to clarify, while holding property in an LLC has other benefits, it will cause your *taxes* to go up, not down. States charge ongoing annual taxes simply for holding an LLC. Also expect an increase in related costs such as accountant fees, etc. also. I’m looking at removing my property held in an LLC and revert to direct personal ownership because of the high tax costs. While there are other benefits, they are rather limited in practical use and to me the costs outweigh the benefits.
Also, to the person talking about depreciation, yes depreciation only allows a delay or postponement of taxes due. Eventually you will pay the piper. Remember depreciation is only an accounting entry; it has nothing to do with the income or profit that your investment (hopefully) generates.
informative article, thank you.
many people think that a LLC is the greatest thing since sliced bread.
but for the small time owner i’m discovering this is not always the case.
i might just increase my umbrella policy instead.
There are plusses and minuses to every legal ownership option. Savvy buyers think it through before signing the contract. Thanks for your comment.
Ilyce Glink, Publisher
If I own several rental properties, and I want to use one of them for more than the 14 days or 10% of the days it is rented out, can I combine all of the properties into a “lump sum” and therefore use all the other days that the other properties are rented out in my IRS calculation?
For example, if I own properties A, B, and C, and A and B are rented out 365 days a year. But C is only a seasonal property in a ski town and is only used about 10 wks/70 days where it generates rent. According to the IRS rules, on property C, I am only allowed 10% (7 days) or 14 days, the latter being larger. So if I were to use my ski place for a 3 wk holiday (21 days), can I combine the days for all of my rental units: 365 + 365 + 70 = 800 days total rented out. Thus, am I allowed up to 80 days (10% of the combined days of rental for the 3 rental units in my LLC)?
I’m no expert but i also have a few properties. a couple points:
– how will the IRS know that you were hanging out in the place for 3 weeks of the year?
– if a property is AVAILABLE for rent 365 days a year, then that is what counts. if the property was listed as available to rent but remained vacant because it was off season, then it still counts as a 365 day rental. i doubt that it matters if you were spending time there, perhaps doing some maintenance and cleaning the place up while you’re there as part of your rental management.
(more to the point, I don’t think you can bundle them and claim the total across multiple properties as you describe, but again i’m not an expert)