Apr 21, 2008

Are Property LLCs Worthwhile?

A colleague pointed me to a blog (Dos and Don'ts of Holding Home's Title in LLC) that recommended several strategies for limiting an owner's legal liability for rental properties. One was extending the owner's homeowner and umbrella insurance policies to cover rental properties; another was the use of separate LLCs to hold title to each rental property. A third recommendation was to add a second member to each property LLC to help make it more official and less prone to legal attack. Here is the response I posted as a comment to the blog:

I'd like to offer several observations and critiques of this article's analysis:

The article implies that homeowner's and umbrella policies automatically extend to commercial real estate. This is probably the case for single-family income property owned by a homeowner, since insurers sometimes agree to extend a homeowner policy to single-family rentals (for an extra cost). But if the rentals are multi-family, the owner probably needs to take out a separate commercial policy on each property.

Also, it is unlikely that an existing lender will allow the assumption of existing property debts (mortgages, equity lines, etc.) by the LLC. The owner will need to be negotiate new notes on each LLC property (which should be done prior to forming the LLC), and he no doubt will have to personally sign on each LLC note. The bottom line is that the owner will remain personally liable for the most important type of ongoing LLC liability -- LLC real property indebtedness.

Another complication: Generally, entities, such as co-owned LLCs and partnerships, can't qualify for favorable (tax-deferred) tax treatment when they trade one commercial property for another. Clever financial and tax advisors structure complicated property ownership arrangements and transactions that seek to get around the technical problems that can arise in this context, but expect to pay extra for these inventive and sometimes uncertain LLC-like-kind property swap strategies.

Forming a single-member LLC, which will be treated as the sole proprietorship of the property owner for tax purposes, can be burdensome in some states, in terms of annual filings and fees. For example, in California, the LLC has to prepare and file a separate annual state LLC informational return, must pay an annual $800 entity-level fee, and is subject to additional annual entity-level taxes that can reach almost $12,000. This additional tax can pose a real problem for property LLCs, since the additional tax is based upon gross receipts, which can include the value of real property owned by an LLC. When you multiply these costs by the number of separate LLCs (one per property, as recommended in the article), the tax and time expense to maintain the LLCs can be onerous.

Finally, co-owned LLC's involve even more tax complexity (the article recommends adding a second LLC member). In that case, the LLC is treated for tax purposes as a partnership, which means, essentially, that contributed real property is considered sold to the separate LLC tax entity (it is no longer consider a separate asset of the owner in which she holds a separate tax basis). After a property transfer, the LLC will have its own basis ("inside basis") in the property, and each co-owner calculates their basis in their LLC interest ("outside basis") separately. The basis of the non-contributing member will get the benefit of a share of existing indebtedness on the property (according to the non-contributing member's interest in the LLC), and the original owner's basis will be correspondingly reduced. There's a whole lot more complexity, such as special presumptions and tax consequences that occur if there are distributions of property of cash within two years of the transfer of property to an LLC, special LLC-level tax elections, necessary adjustments of each LLC member's basis each time the LLC pays down the debt on the property, and much more. In short, co-owned LLCs, like partnerships, requires expert (and costly) tax expertise.

Is it worth forming an LLC to try to limit the owner's personal exposure to liability that may arise in connection with the operation of rental property, such as slip-and-fall claims and other non-debt related legal liabilities? Normally, it isn't, as long as the owner carries a reasonable amount of commercial insurance on each property.

Copyright 2008 by Anthony Mancuso

This article is provided as information and opinion. Please check with a legal or tax adviser for legal or tax advice.