Should I Put Inherited Property In LLC?
Reader wants to know if using an LLC to transfer property ownership after death is the best way to avoid probate
Q: I inherited a parcel of land upon my father’s death. His wishes were for the property to remain in the family for my children. In order to prevent any tedious probate in the event of my death, I formed a limited liability company (LLC) with me and each of the children as members. Are there any tax consequences I should be concerned about?
A: Before we get into the tax consequences, we’re not sure if using the LLC was the best option. You were trying to avoid probate and allow the property to pass from you to your children upon your death.
Is an LLC the best way to pass down inherited property?
An LLC is a company structure. You and your children can be members of that LLC. But there are some wrinkles to choosing this structure. First, are your children minors? If so, who will represent their interests in the LLC to make a decision upon your death? If you die, have you addressed and documented the transfer of your membership interest in the LLC to your children?
The LLC wouldn’t automatically answer these issues. We hope you worked through these questions carefully with your attorney. If not, your children might still need probate to transfer your LLC membership interest. We hope the operating agreement for the LLC provides a structure to allow the property to transfer from each member to another upon the death of one member. The document will need to have a specific mechanism to allow for the transfer of membership interests without having to go through probate.
Think twice before putting property in an LLC
For our readers, here’s another reason to think twice before putting real estate into an LLC just to escape probate. Creating the LLC structure costs money. You pay to create it and then you pay an annual fee to the state in which the LLC is formed. You have to file an annual tax return for the LLC and may have to pay an accountant to file the return.
Frankly, we think a living trust would have been a less expensive option. A living trust allows you to control the property entirely during your lifetime with automatic transfer of control and ownership interests upon your death.
Which is a nice segue to the topic of taxes. We don’t know how you set up the structure, so we can only guess as to some of the potential issues you might face now and in the future by holding the property in the LLC.
If you put inherited property in LLC, there may be tax consequences
Certainly, when your father died, you inherited the property on a stepped-up basis. That is, the land would be valued at the current market rate at the time of his death. If you kept the property in your name, your kids would inherit the land at the land’s market value at the time of your death. With a stepped-up basis, the heirs get the land at its increased value and the new generation would not have a tax to pay if they immediately sold the land shortly after they were to inherit the property.
Here’s how it might play out: Let’s say the land was worth $1,000 when your dad purchased it. When your dad died, the land was worth $100,000. If you turned around and sold the land shortly after he died, you’d pay no taxes on that sale. For Internal Revenue Service (IRS) purposes, you inherited the land at a value of $100,000 and sold it for $100,000. Hence, you had no profit and no tax to pay.
The same is true in the future, assuming tax laws don’t change. If the land was worth $500,000 at the time of your death, your kids could sell the land and pay no taxes on that sale if they sold shortly after your death.
But if you put your kids on title to the land shortly after your dad died, your kids would not get the full stepped-up basis at the time of your death.
How to Avoid Paying Capital Gains Tax on Inherited Property
Let’s say, you have three children and the four of you are equal owners in the LLC. Each person has 25 percent of the LLC. If the property is worth $100,000, each of you would have a basis of $25,000. When you die, your kids would inherit your 25 percent interest.
If they sell the land shortly after you die, your three children might not have a tax to pay on your 25 percent interest. But, they would have to pay tax on the profit from the sale of the land. Why? Their cost basis is $25,000. So, if the land is worth $500,000 when you die and they sell, each kid will have a substantial tax to pay on their share of the LLC. But they wouldn’t have tax to pay on your 25 percent share that they all would inherit from you.
Putting a Rental Property in an LLC to Minimize Taxes
We’ve simplified our example substantially. And, there are other tax issues that go along with an LLC ownership that require a longer explanation. These issues may depend on whether your kids are minors or not, what other assets everybody owns, who’s paying for any expenses on the ownership of the land, including real estate taxes, insurance and any maintenance, and whether you’re earning revenue from the property.
Talk to an estate attorney or tax expert who can help you find the right solution.
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Our financial planner suggested putting our rental property in LLC for liability protection. I feel, for the reasons you mentioned, we don’t need to do that but what is your thoughts about the liability issue? We have normal homeowners insurance plus an umbrella policy. Our rental insurance has $500,000 liability coverage and our umbrella adds another $500,000, with a Policy Limit (per occurrence) of $3,000,000.
Thanks!
Jim,
It depends on how big a risk you’re taking. By that I mean, how much you and your spouse are worth, whether there is a potential for creditors coming after you, or even if someday you expect (or hope) to qualify for Medicaid. Your financial planner is being smart about the liability risk, but if you carry a mortgage on the property, it may be difficult to keep your interest rate (per your lender) if you change title to the trust. Also, are you just going to have this one property or are you starting a business where you might end up with a handful of rental properties? If you’re going to expand the business, then you’ll want to look at an LLC for protection. Or, if you’re wealthy and worried about someone suing you just because they perceive you to be a big fish, then an LLC is helpful.
But you’ll need to file a separate tax return, keep separate books and bank accounts, and keep up with your state’s requirements for a corporation. It’s a lot for one small rental property. Talk with your financial planner to map our the real risk and then perhaps ask if upping your insurance will ameliorate the risk.
Good advice Ilyce, thanks!
You’re very welcome.