If you own a piece of real estate, or are planning on buying one, you may be wondering if you should form an LLC to own the property, or if you should own the property yourself (or with your partners, if you have any). In particular, you may be wondering if there are tax benefits to forming an LLC to own the property.
To help you answer those questions, this article will discuss the following:
- What is an LLC?
- How is an LLC taxed?
- What are the main tax benefits of an LLC in general?
- Are there tax benefits to owning real estate through an LLC?
- What are the main non-tax benefits of having an LLC own the real property?
- Are there disadvantages of owning real property through an LLC?
What is an LLC?
An LLC is a statutory form of business entity. Here’s what this means.
- Statutory means that it can only be formed if there is a state statute that says it can be formed. (Don’t worry, every state has an LLC statute). It also means the LLC has to comply with the provisions of the LLC statute under which it’s formed. In contrast, for example, a sole proprietorship is not a statutory entity. It exists simply by an individual starting to do business. There is no need for there to be a statute saying the individual can do that.
- Business Entity means that the LLC has its own legal existence, separate apart from its members. (The owners of an LLC are called “members”.) An LLC can be thought of as sort of an artificial person. It can sue and be sued in its own name, enter into its own contracts, own property (including real estate), it has some Constitutional rights, and is liable for its own debts and obligations. On the other hand, a sole proprietorship, for example, does not have an existence separate from the sole proprietor.
How is an LLC taxed?
The way an LLC is taxed for federal income tax purposes depends upon two factors – whether it’s owned by one person (a single member LLC) or more than one person (a multiple-member LLC), and whether the member or members stay with the LLC’s default tax status or elect to have it taxed differently.
- Single member LLC: The IRS taxes a single member LLC, by default, by disregarding the LLC’s existence. That doesn’t mean the LLC ceases to exist, only that the IRS is ignoring it for federal income tax purposes. The LLC’s income is therefore considered by the IRS to be the member’s income, and it is included in the member’s personal income tax return. This is the same as the IRS taxes a sole proprietorship.
- Multi-member LLC: The IRS taxes an LLC that has more than one member, by default, as a “pass-through” entity. That means the LLC does not pay income taxes, but its income ”passes-through” to the members, who pay the taxes. The LLC does, however, have to file an information return with the IRS. This is the same as the IRS taxes a general partnership.
- Election to change tax status: Your LLC doesn’t have to be taxed in the default way. By filing an election form with the IRS, you can have your LLC taxed as follows:
- As a C corporation, meaning the LLC will pay income taxes at the corporate rate and the member or members will pay personal taxes on the income distributed to them. This is referred to as “double taxation”.
- As an “S corporation, which is also a “pass-through” tax entity. However, your LLC must meet certain requirements of the Internal Revenue Code such as not having any foreign owners or two classes of ownership interests.
It’s important to remember that if you elect to have your LLC taxed like a corporation that doesn’t make it a corporation. It’s still an LLC, it’s just an LLC that’s taxed under the same provisions of the Internal Revenue Code as a corporation.
What are the main tax benefits of an LLC in general?
There are two main tax benefits that an LLC provides.
- Avoiding double taxation. The fact that an LLC can avoid the double taxation of a C corporation without the restrictions the Internal Revenue Code imposes on S corporations is considered the major tax benefit of the LLC.
- Flexibility. Another benefit is that an LLC can also elect to be taxed as a C corporation, which in some circumstances can actually result in tax savings for the LLCs and their members, and, if they qualify, they can elect to be taxed as an S corporation (which can be a benefit when it comes to self-employment taxes). If you have a sole proprietorship you can’t change the way you’re taxed, although if you have a general partnership, you can.
Are there tax benefits to owning real estate through an LLC?
In part, whether there are tax benefits depends on why you bought, or are going to buy, the property. Real property purchases are made for various purposes, including:
- To rent the property out and earn rental income
- To buy a distressed property, renovate it, and sell it for a profit
- For long-term investment (selling in the future after its value increases)
- To own as a residence (not for income generation)
Here are some things to keep in mind as you consider whether to form an LLC based on possible tax benefits.
- If the real property will generate income, you can have the income taxed to you personally whether you own it in your own name or you form an LLC to own the property. You can also use property related deductions like interest on mortgages, depreciation, and operating expenses.
- If you are to be the sole owner of the property, by forming an LLC you would have the option of being taxed as a C corporation or S corporation. In some cases, for example when the LLC generates significant profits that will not be distributed to the members, C corporation taxation can save you money. And if the LLC is taxed as an S corporation, that can save you money in self-employment taxes.
- If you own the LLC with other people, you can have the profits and losses, deductions, and other tax items generated by the property passed through to you and your fellow members whether you operate as a general partnership or an LLC. You would also have the option of corporate taxation.
- Where there are multiple owners, an LLC can allocate profits, losses, deductions, and other tax items in almost any manner they agree to in their operating agreement.
- It’s always a good idea to consult with a tax adviser if taxation is a major concern for you in deciding how to own the property.
What are the main non-tax benefits of having an LLC own the real property?
The decision whether or not to form an LLC to own real property should involve considerations other than taxation. We should also note some of the other benefits of the LLC. Here are some non-tax benefits to consider:
- Limited liability. The main benefit of using an LLC to own property over owning it yourself is that the LLC is liable for its own debts. Your liability as the LLC’s member is limited to what you contributed to the LLC. Say someone trips and falls on the property and wants to recover damages for their injuries. If you own the property, you can be sued and held liable. Your personal assets - house, car, bank accounts - can be used to pay the injured party. But if the LLC owns the property, the injured party has to recover from the LLC’s assets, not yours.
- Flexibility of management and financial rights. Another benefit of the LLC, particularly where there are multiple owners of the property, is that the members can split their management and financial rights in almost any they want (as long as they outline it in their operating agreement). Clarifying who has to do what and who gets what, right from the start, can help prevent costly and divisive disputes among the owners later on.
- Privacy. One reason some people form an LLC to own property is for privacy, they don’t want their name on the deed. If the LLC owns the property, it’s the LLC’s name on the deed. And in some states the members’ names don’t have to be included in the LLC’s public filings. Residential ownership for this reason is done, in particular, by high income individuals, celebrities, political figures, or controversial figures when buying a personal residence. (Note, a recent federal law will require a report to be filed with the federal government naming the beneficial owners of an LLC that purchases a residential property in a non-financed sale. There are exceptions. And while the LLC doesn’t have to file the report and its owner’s names won’t be publicly available, you still may want to talk to an attorney about this new law if privacy is your principal goal in having an LLC own your residence).
Are there disadvantages of owning real property through an LLC?
Just to give you the complete picture, let’s look at some of the disadvantages of owning real estate through an LLC.
- Costs. Basically, it’s more expensive to form an LLC than it is to not form an LLC. There are filing fees upon formation and in many states annual report fees and franchise taxes. You’ll need a registered agent to receive service of process on your LLC’s behalf and it’s highly recommended you use a professional registered agent, regardless of the additional cost.
- Compliance. As we said in the beginning, an LLC is a statutory entity and you have to comply with the LLC statute.
- Financing difficulties. If you’re trying to get a mortgage it can be harder if the LLC will own the property. Some lenders won’t give a mortgage to an LLC and other lenders may charge a higher interest rate or require a personal guaranty.
- Benefits available only to individual residence owners. A homestead exemption, which can protect a residence from creditors, is typically available for individual property owners but not necessarily for LLC owners. There can also be certain tax benefits available to individual residence owners that aren’t available to LLCs that own property, such as the capital gains exclusion on the sale of the residential property
Conclusion
In general, LLCs are considered to provide tax benefits. However, whether owning a piece of real property with an LLC will provide more tax benefits than owning it as an individual will depend upon various factors. A legal or tax adviser can help you figure that out. Regardless, LLCs provide many non-tax related benefits and those should be considered as well.
