Reduce Fincancial Risks by Forming an LLC

Acquiring and maintaining real estate can be an extensive and expensive venture. Searching to find just the right investment property  - whether it be residential or commercial can all make for a stressful process. Then after acquiring the property, you have to work hard to maintain it, which often requires more capital for upgrades and/or repairs.  You’ve put a lot of time and energy into it and probably consider it a precious asset.

However, you may not be the only one to see value in your property. In the world today, lawsuits abound. Car accidents happen. Business deals can go wrong and people can get injured on your property.

If a property is held in the owner’s legal name, this can leave real estate very vulnerable to being used by others to force a settlement or to being attached, if a judgment is entered against you. While insurance can ease the burden, it has limits and might not provide adequate protection to your real estate, especially if any negligent acts by you or your agents result in serious injuries to others.  If you’re not careful, you can lose the very property that you worked so hard to get and might even jeopardize other personal assets, including your home, bank accounts or other properties. In these instances, placing your property in an LLC can help protect your real estate.

Reduce Fincancial Risks by Forming an LLC

Acquiring and maintaining real estate can be an extensive and expensive venture. Searching to find just the right investment property  - whether it be residential or commercial can all make for a stressful process. Then after acquiring the property, you have to work hard to maintain it, which often requires more capital for upgrades and/or repairs.  You’ve put a lot of time and energy into it and probably consider it a precious asset.

However, you may not be the only one to see value in your property. In the world today, lawsuits abound. Car accidents happen. Business deals can go wrong and people can get injured on your property.

If a property is held in the owner’s legal name, this can leave real estate very vulnerable to being used by others to force a settlement or to being attached, if a judgment is entered against you. While insurance can ease the burden, it has limits and might not provide adequate protection to your real estate, especially if any negligent acts by you or your agents result in serious injuries to others.  If you’re not careful, you can lose the very property that you worked so hard to get and might even jeopardize other personal assets, including your home, bank accounts or other properties. In these instances, placing your property in an LLC can help protect your real estate.

WHAT IS AN LLC?

LLC stands for Limited Liability Company. It is a business entity that includes features of a partnership, sole proprietorship and corporation that can ensure that company owners or members are not personally liable for the debts and liabilities of the entity. It is similar to a sole proprietorship in that it can be owned by one member, which results in a single-member LLC. While a partnership and/or sole proprietorship may require little to no paperwork and provide no protection from debts or liabilities arising from lawsuits, an LLC resembles a corporation in providing such protections with the filing of some documents.

In California, an LLC may be set up to engage in any lawful business activity, “except the banking, insurance or trust company business.” Additionally, using an LLC for a licensed practice, such as for doctors or lawyers, is generally prohibited.

HOW DO YOU START AN LLC?

An LLC is fairly easy to start. It can be done online, by mail or fax by filing your Articles of Organization with the Secretary of State along with a $70 filing fee.

The Articles of Organization is the document used to create your LLC, which asks for basic information such as the name of the organization, location, names and addresses of the owner(s) and a registered agent (one who is required to accept service on behalf of the organization).  

Next, you must also file a Statement of Information ($20 fee) and an operating agreement. The operating agreement is simply a legal document detailing ownership and the operating procedures of the LLC.

Additionally, an Employment Identification Number (EIN) must be obtained from the IRS. This is simply a 9-digit number used to identify your entity, similar to a social security number, except it is for the business.

HOW DOES AN LLC PROTECT ASSETS?

Limited Liability Companies are similar to corporations in that they can provide limited liability protection for its owners-as its name implies.  [California Corp. Code Section 17101(a)] Any judgments issued against the LLC may result in seizing its assets, if any, while leaving the personal assets of the individual member/owners protected.

Additionally, a personal creditor of an individual member of the LLC may be precluded from seizing the assets owned by the LLC if the operating agreement is properly drafted. For example, a personal creditor would be from personal activities as opposed to business activities of the LLC.

WHAT ARE THE ADVANTAGES AND DISADVANTAGES?

First, setting up an LLC is fairly easy and the set-up costs (including the $800 franchise tax fee), are tax-deductible. The entity can be set up like a sole proprietorship so that it does not pay income taxes for itself. Instead the owners can list the business profits and losses on their personal tax returns. This allows you to avoid double taxation- being personally taxed and having your entity taxed as well. Unlike a corporation, an LLC is not required to hold annual meetings or memorialize minutes from such meetings. Additionally, while a California LLC is required to pay the annual $800 franchise tax, an LLC is not required to pay a transfer tax whenever it sells or transfers the property to another owner.

Protecting your real estate requires transferring the property into the ownership of an LLC. However, keep in mind that if a property is being financed, some mortgage lenders are hesitant to lend to LLCs. Likewise, there are some mortgages that include a “due on sale” clause requiring the complete payment of the balance owed on your mortgage upon the transfer to another entity. Therefore, prior to transferring any properties to an LLC, the matter should be discussed with your lender.

Next, if an LLC files for bankruptcy, the members don’t have to use personal money to pay for any debts owed by the company. Also, if you own several different properties, each one can be placed in a separate LLC, thereby protecting them from potential lawsuits arising from your ownership of other properties. However, if you own three properties and place them all in one LLC, if a lawsuit or liability arises as to one of the properties, each of the other properties are at risk since one can seek to seize the assets owned by an LLC. If each property is placed in a separate LLC as a separate business, each particular property will be insulated from any liability arising from one of the other properties. In addition, any other personal assets will be protected.

Additionally, an LLC is helpful for passing on appreciation to a family member or spouse without incurring any additional capital gain liability. Normally, if a property appreciates after the purchase date, when the owner dies, the heirs will have to pay taxes on this added value. At death, any assets owned in an LLC will get a step -up in basis for any share owned by the decedent.  With a step-up basis rule, any gains are calculated based on the asset’s value at the time of death rather than at the time of purchase. Generally speaking, if you pay $100,000 for a rental property and it is owned by your LLC (assuming it is taxed as a partnership) , when it is later worth $500,000, your estate will owe no income tax for the gain in value upon your death as to your share. A member’s interest receives a step-up in basis upon the member’s death.  If that same property were held in a corporation, the additional tax would be owed. When the decedent dies, and heirs take possession of the property from ownership under a corporation, they will owe taxes on the gain if the property is sold. However, if the property is under the ownership of an LLC, heirs will get the stepped-up basis, automatically increasing the basis of the property to the current market value. Thus, the death of a member creates a new basis based on market value for the decedent’s share.

PERSONAL RESIDENCE

Generally speaking, you probably do not want to put your personal residence in an LLC.  A major disadvantage when your personal residence is owned by an LLC is the loss of federal capital gains exclusion on the sale of a personal residence while living. Under current law, up to $250,000, if single, or $500,000(if married) can be tax-free profit to a seller of one’s personal residence pursuant to the 1997 Taxpayer Relief Act so long as the property remains one’s personal residence for at least 2 of the past 5 years. If a personal residence is placed in an LLC, this capital gains exclusion is lost if sold during the owner’s lifetime. To avoid this, don’t put a personal residence under the ownership of an LLC if it may be sold while living.

FINAL THOUGHTS

An LLC is fairly easy and inexpensive to start and offers many benefits to owners of real estate, including the protection of personal assets from lawsuits and other creditors as well as offering an avenue to transfer property, profits and interests to family members while avoiding huge tax penalties.

For more information about starting an LLC or using it as a tool to protect your real estate investments, stay tuned for upcoming webinars or contact an attorney at Tyler Law today.