Issues When Holding Residential Real Estate in an LLC
Many of our investor clients seek counseling regarding the formation of a limited liability company to own and manage one or more one-to-four-unit residential properties. We thought it would help to address some issues which should be considered when deciding to use an LLC to hold real estate investments.
There are some advantages in owning real estate in an LLC, however, there are some issues which also need to be considered.
For instance, many small real estate investors believe that an LLC will offer tax advantages. It is possible that there might be some tax advantages, but for most small investors – ones who own one to three or four single-family residences or duplexes – there are few tax reasons to create an LLC.
A single member LLC or an LLC owned by a married couple, is what the IRS calls a “disregarded” entity. Here is a quote directly from the IRS website: “For income tax purposes, an LLC with only one member [or a married couple] is treated as an entity disregarded as separate from its owner, unless it files Form 8832 and affirmatively elects to be treated as a corporation.”
When the LLC is a disregarded entity, the IRS treats is as though it did not exist. All income and expenses are reported on the owner’s tax return just as they would be if there were no LLC.
Usually, having the LLC disregarded is an advantage because no tax return is required for the LLC. Income and expenses are just included with the owner’s 1040 tax return.
There are ways to create some tax advantages, but they rarely apply to small operations where the owner is not paid a salary for managing the properties.
The primary reason for a real estate investor to hold title in an LLC is to eliminate or reduce potential liability if someone is injured on the property. Texas law requires property owners to take certain measures to ensure that their property is safe. The laws which require this are called “premises liability” laws. There are many types of suits against property owners based upon premises liability. Many involve damages which can be easily covered by liability insurance. But when a serious injury or death occurs, the damages may be quite large – larger than the coverage provided under most liability policies. If the injured party can prove willful misconduct or gross negligence in a death case, the court may award exemplary damages to punish the offender. Exemplary damages can be much, much larger than most property owners can afford to insure against.
The primary benefit of an entity such as an LLC is to provide protection against large uninsurable losses. If an LLC owns the property, it will be liable for the uninsured losses, not the underlying owner of the LLC. That will mean that the property in the LLC is at risk, but other property owned by the LLC owner should be protected.
The instances when a property owner faces circumstances which could cause uninsured losses is small, but there is always some level of risk. For many property owners, this will justify creating an LLC. There is a small risk but a potentially very large downside.
If a property owner creates an LLC to own and manage real estate, the property must be conveyed into the LLC. If it remains in the property owner’s name, there will continue to be personal liability for any loss or damages. If the property has a mortgage against it, the mortgage will almost certainly prohibit transfer of ownership of the property without consent of the lender.
The mortgage provisions which prohibit transfers without lender consent are called “due on sale provisions” because they give the lender the right to call the loan due if they are violated. There is no way to transfer property into the LLC without violating these provisions, so the property owner must be willing to accept the risk of violating the due on sale provisions.
Lenders rarely call loans under a due on sale provision and, if it does call the loan and if the property owner controls the LLC, the property can be deeded out of the LLC and back to the property owner which will cure the default. The risk of a loan getting called due is low, but it is not non-existent.
When a property owner transfers property into the LLC, any leases to the LLC must also be transferred. This is a rather simple process, but it should not be skipped. A lease from an owner who does not own the property because it was transferred may not be able to enforce the lease.
The final issues I want to discuss are property insurance and property taxes. The property owner will need to notify the insurance company that the LLC is the new owner. The company will amend its policy to reflect that the LLC is the owner. Failure to notify the insurance company could jeopardize the coverage. Since the lender is an insured party, it will receive a new insurance policy with an owner who is not the borrower. This will give the lender immediate notice that title to the property has been transferred.
Tax records will also be changed to show that the LLC is the owner. If the lender is escrowing for taxes, it will receive an annual tax invoice indicating an owner other than its borrower.