Whether California Residents should Hold Real Estate (Rentals and/or Investment Properties) in Limited Liability Companies (LLCs) or other Entities:
The most common entity used to hold real estate in California is a Limited Liability Company (LLC). Corporations, primarily S-Corps, are also used to hold rental and investment property but, as discussed later, they are typically less advantageous than LLCs and other partnerships for estate planning and other reasons. LLCs are technically “Partnerships,” although it is permissible to have a Single or Sole Member. For purposes of this article I will focus on individuals (singles, married couples, etc.) who own 1 – 5 properties that have a combined Fair Market Value (FMV) of less than $2 million. If the final section I will offer a non-entity alternative for your consideration.
Benefits of LLCs:
When considering holding property in an LLC often one the most appealing aspects initially is the limited liability provided to the Member or Members. But, another major benefit is the flexibility the structure allows, when properly planned and set up, to move assets in and out, add or remove Members, etc. without creating a taxable event. LLCs are not technically required to maintain books, as Corporations and S-Corporations are, but would be ill advised not to have good books, so some of the technical requirements are less stringent than those for corporations. With both LLCs (Partnerships) and Corporations it is critical to maintain “active” and “good” status with the State of California. Allowing good status to lapse with the State (Secretary of State) can cause the limited liability of members, partners and shareholders to be lifted and thereby potentially exposing them to significant personal liability.
In order to maintain the entity’s status as an LLC it is critical to operate as a stand-alone business. The entity should have its own bank account, all deposits should go into the account, expenses paid from the account and preferably its own set of books maintained. Avoid using LLC checking accounts, debit and credit cards, etc. to directly pay for personal expenses. Commingling personal and entity funds can jeopardize the limited liability of an LLC and Corporation. If LLC funds are needed for personal use, other entities need cash, etc., consider making a member distribution or loan to the member(s) or related entity. Also, identify payments or transfers as “Inter-Company” (I/C) Loans, e.g. I/C – LLC 1 or I/C – Member 1. Initially recording transactions correctly can avoid a great deal of headaches down the road if such transactions are then attempted to be corrected or “cleaned up.” Be certain the I/C is recorded on the lending and the borrowing entities’ books. If there is more than one entity and money is loaned between the entities it is important to track and maintain records of the Inter-Company debts and receivables – even when common ownership is 100%. Proper recording of transactions may take a bit more time up front, but if a taxing authority were to scrutinize an entity’s records in future months or years the time, expense and stress that is ultimately saved can be enormous.
One of the primary tax benefits of holding real estate in an LLC (or other type of Partnership) is that when a member dies, their heir(s) get a “stepped-up” cost basis in the inherited property held by the LLC. For instance, if Grandparent A bought a rental property in 1970 for $50,000 (which was subsequently put in/contributed to an LLC) and on the day Grandparent A died the Fair Market Value (FMV) of the property was $500,000, the heir(s) would receive the inherited property with a $500,000 cost basis – the LLC’s cost basis would be $500,000 assuming he was the LLC’s sole member. The heirs could have the LLC sell the property, assuming the sales price was the same FMV as the day of Grandparent A’s death, and recognize $0 gain on the sale and thus $0 tax. Or, the heir(s) could continue to operate the property, within the LLC or not, as a rental and depreciate the additional non-land portion of the $500,000 cost basis. If the property had been held in a Corporation (C or S) the property would not receive a stepped-up cost basis, but the stock Grandparent A held on the date of his death would be stepped up to the stock’s FMV at the date of death. There would be no additional Depreciation, as with an LLC/Partnership, and the sale of the property could result in a significant gain and income tax liability.
Other Considerations for LLCs and Other Entities:
LLCs and Corporations are required to pay the California Franchise Tax Board an annual Minimum Tax of $800 if they are registered and/or doing business in the state. Also, California imposes a Gross Receipts fee (deductible for federal and California tax purposes) on LLCs. For Rental Real Estate the gross fees are based on Rental and other related gross income. The fee is $900 when receipts reach $250K, $2,500 when receipts reach $500K, $6,000 when receipts reach $1 million and $11,790 when receipts reach or exceed $5 million. In addition to the taxes and fees there are the costs of filing tax returns (California requires a return be filed for Single Member LLCs – to collect the LLC fees and other information), maintaining active status with the State, maintaining adequate accounting records, etc. Tax and fees can quickly exceed $1,000 per year. Annual costs are a significant consideration.
Final Thoughts and Ideas:
If a Taxpayer holds a few properties of relatively modest value, I would suggest analyzing the type of liability the properties might create (e.g. a gas station or other property with contamination issues, a residential property with a significant amount of deferred maintenance, etc.), and determine that a larger liability insurance policy may offer equivalent liability protection and cost substantially less. These considerations should be discussed with your tax, insurance and legal advisers.
If you have questions or would like to discuss these issues, please feel free to contact Scott at (909) 792-5056.