Question of the week: Should we put our rental property into an LLC?
Answer: As many of you know, LLC stands for Limited Liability Company, which is a legal entity has some components of a corporation, a partnership and sole proprietorship. Like each of those entities, LLCs have plusses and minuses depending on the purpose of creating an entity for ownership.
For real estate, properties are broadly divided into two main categories, residential and commercial. In general terms residential real estate is considered properties that are 1-4 units (inclusive studios, condos, own-your-owns, etc). Commercial property is considered as commercial business properties, and residential properties with five units or more, or residential properties that also have a commercial entity in place. An example of the latter may be a building with retail stores on the street level and apartments above the store.
For our discussion today, we will concentrate on whether or not to put residential rental properties into LLCs.
For the past few years, we have seen more and more clients with residential rental properties in LLCs, almost always having purchased the property as individuals, either as sole owner or with spouse or significant other, and then transferring the property into an LLC they created for the purpose of owning the property.
There are several benefits for owning property in an LLC, primarily is the liability shield they create to protect you from personal liability. Another is the LLC has pass-through taxation, meaning there is no separate tax return for the LLC, it is reported directly on your personal tax returns.
The primary benefit that most of my clients who have transferred their residential investment properties to LLCs has been the liability protection afford them to protect their current assets and future income from lawsuits.
One less tax return and personal protection should someone become injured on your property, sounds like an easy decision.
The biggest downside to have residential property in an LLC is when it comes to obtaining a mortgage for the property as loans to LLCs are not as available as loans to individuals and general have different terms and rates. The biggest factor being that Fannie Mae and Freddie Mac do not fund loans to LLCs, therefore taking out the biggest mortgage market for residential real estate with the longest terms and lowest rates.
This issue arises when refinancing a property in an LLC, or if selling the property and purchasing another property under the guidelines of an IRS 1031 exchange to avoid paying capital gains taxes on the appreciation of the property being sold.
In a 1031 exchange, a property owner sells a rental property and purchases another property by transferring the net proceeds from the sale. There are several rules to the 1031 exchange. A few are, that the new property has to be of equal or greater value to the sales price of the property being sold (the “downleg”), all of the proceeds from the sale (the “boot”) must be invested in the new property, and the owner(s) of the new property must be the same as the property being sold.
The last regulation is where LLCs come into play. Let’s look at a realistic scenario. You purchased a new home on 1st Street in 2012 for $450,000. After living there for five years you purchased a new home on 2nd Street in 2017 and converted the 1st Street property to an investment property, at the time the value had increased to $550,000.
In 2019 you transferred the property to 1st Street LLC, with you and your spouse as the managers/members of the LLC.
Today the home is worth $975,000 and you only owe $250,000 on the mortgage. There is an opportunity to purchase a 3-unit property for $1.3 million that by transferring your equity in 1st Street to purchasing the new property will greatly increase your monthly positive cash flow. To avoid taxes, you need to sell 1st Street, have all the funds go directly to the new purchase, and buy the new home with 1st Street LLC being the new owner.
Because the LLC is purchasing the property, any lender will be funding the loan for a business entity as owner and requiring members of the LLC to be personal guarantors of the loan. Instead of a relatively low 30-year fixed rate mortgage from Fannie Mae or Freddie Mac, you are likely looking at getting a hybrid-ARM mortgage that will have a fixed rate for a period (3, 5, 7, 10 years) and then become an adjustable mortgage.
The trade-off for the personal liability protection and pass-through taxation you receive from having your residential investment properties in an LLC is that you have fewer mortgage options, that will be less desirable in terms of rates and fees than if you own the property as individuals (or in your family trust).
For some investors the financing is more important than the personal liability protection and they prefer to keep their properties out of LLCs, for others the risk of a potential lawsuit outweighs the reduced financing options and put their properties in LLCs.
Which is best for you? There is no pat answer. The mechanics and regulations are more complex than the broad overview above when it comes to tax deferred exchanges and transfers. As well, the legal obligations and tax benefits of LLCs.
Before making the decision I strongly suggest you consult your tax preparer to determine how an LLC may impact you and your property ownership, an attorney to learn about the protections are and are not afforded to you, and finally, your insurance agent to see what products are available that can protect you from personal liability and what the cost is for the protection. Weigh all these factors with against the costs associated with an LLC, from filing fees to mortgage options, and then determine which method of ownership is best for you and your family.
Have a question? Ask me!
Flying. That describes our economy in the 2nd quarter as GDP grew at a 6.5% rate, resulting in our nation’s economy being larger as we entered July than it was pre-pandemic. Consumers are driving the growth, and in June increased their spending by 1%. Despite declining federal supplement checks for unemployment as many states have ceased the bonus funds, personal incomes rose 0.1% in June. Half of the increase in consumer spending was the result of higher prices in the economy as inflation rose 0.5% for the month and prices for goods and services are 4% higher than June 2020. With inflation outpacing wage increases, and the potential of the Delta variant impacting the economy and whether some shutdowns return there is concern for the sustainability of growth in spending and economic activity. The economic news today has little impact on rates, while historically the data would push rates up.
The big reason for the lack of impact is the Federal Reserve is still purchasing $120 billion every month in mortgages and U.S. Treasuries. The end of the purchasing program may appear on the horizon soon as Fed news this week indicates that “progress” is being made to the goal of lower unemployment and stable inflation. When the Fed feels this goal has been met it will begin to taper its purchase of financial instruments that impact interest rates.
Rates for Friday July 30, 2021: Despite the economic news that would normally push rates up, the market has been flat all week, as a result, rates are flat for the fourth Friday in a row.
FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS FOR PURCHASE TRANSACTIONS:
30 year conforming 2.625% Flat
30 year high-balance conforming 2.75% Flat
Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.
Like hundreds of thousands of other families in our country, ours was impacted by Covid-19 as Leslie’s father passed away from the virus in January. Also, like hundreds of thousands of families, an appropriate service and remembrance were delayed until family and friends were allowed to remember a father, grandfather, uncle, brother and friend.
This evening, rosary service, and tomorrow, funeral and reception, we will remember Don-Pa, as our children called him, with some tears and laughs. He grew up as one of eleven children on a farm in Iowa, and his midwestern values, humor and wisdom were cause for all who knew him to admire him and call him “friend.”
When I married Leslie, I gained a wonderful father in-law with whom I was able to share some rounds of gold and rounds of whiskey through the years. He will be missed, but never forgotten. Cheers, DonPa!
Have a great week,
Past Weekly Rate & Market Updates can be found on my blog page at my website www.DennisCSmith.com/my-blog