How should you hold your California investment real estate?
The following discussion explains some of the options available to landlords and investors when it comes to protecting real property investments through a real estate LLC.
The aim of this article is to provide insight into the different ways to hold real estate.
We will start with using a limited liability company (LLC) to hold real estate, as well as some of the drawbacks when deciding if an LLC is a protection method.
Two key benefits of forming an LLC to hold real estate are:
asset protection and
the potentially beneficial tax treatment the LLC provides when compared to a corporation.
It is important to understand that in order to have these benefits the LLC must be correctly set up and maintained.
Asset Protection when using an LLC to hold real estate
It has become common knowledge that anytime you own property there is an inherent risk of liability. With that said, a basic estate plan comprised of a revocable living trust and power of attorney will not give you liability protection.
While insurance can help with most foreseeable risks, there are some risks that a standard insurance policy will not cover (such as flooding, earthquakes, mold, sewer backup, and sinkholes). In addition, all insurance has a policy limit. With that said, the amount of damages may extend past the policy limit.
Arguably the most important benefit of forming an LLC to hold real estate is to limit the owner’s personal liability.
For example, let’s say John owns a rental house and puts title to the rental house in a California LLC. John then rents the house to Tenant. While Tenant is living in the house, an old water pipe breaks and the tenant slips, falls, hits their head, and is in a coma.
If a court finds that John was at fault, and enters a judgment against John, having an LLC will limit the amount of damages that John is liable for to the amount of assets that were held under the LLC. In this case, the damages would be limited to the value of the rental property. Thus, while John would still be responsible for damages, he would be able to protect his family home, savings accounts, cars, and other assets.
Secondly, a properly formed California LLC will protect the assets of the LLC against claims by creditors of the owners (members or managers) of the LLC. For example, if John was found to be at fault in an auto accident and there was a Creditor attempting to collect on a judgment relating to that accident, the Creditor would have difficulty attaching to the assets owned by the LLC (the rental property). With a property-formed LLC, along with a well-drafted operating agreement, the Creditor would likely be limited to placing a lien on any distributions from the LLC to John.
Thus, an LLC can provide personal liability and asset protection when used as a holding company for real property investments.
Potential Tax Benefits of an LLC
By default, a holding company with a single owner—including a single-member LLC, for example—is classified by the IRS in the same way as a sole proprietorship. As a so-called “disregarded entity,” both the LLC’s capital gains (appreciation in value of the property) and rental income “pass-through” the company directly to the owner who then pays taxes on this money only at the individual level.
Thus, the owner who uses a Real Estate LLC to hold real property can enjoy the protection of an LLC liability shield while avoiding the double-taxation of some corporate business structures.
Drawbacks of a Real Estate LLC
While an LLC may be the best option for many real estate investors, this may not be so for each and every owner of real property. Sometimes, the time, energy, and resources spent in forming and maintaining an LLC are not worth having a liability shield to protect the individual owner from the threat of a hypothetical lawsuit. One expense that LLC owners need to consider is the minimum $800 California Franchise Tax Board fee which is due four months and fifteen days after the articles of organization are filed and annually thereafter.
For many property owners, having a proper insurance policy may be the best option, and this will be explored further in Part 3 of this series on protecting real property investments.
Ultimately, either of these options can be explored and considered further by working with a San Diego Estate Planning attorney who can set-up your LLC or help you to acquire liability insurance.