We recently moved out of our primary home and planning to rent it out. Also, will put it up for sale soon after or rent-to-own.
In the meantime, I am planning to move it under an LLC using a quitclaim deed. Same members in LLC as the current title, my wife and I.
Say, our original purchase prices in 2010 was 400K, I do a quit claim to LLC for $1. During next text year, we take depreciation of say, 15K. Later, after a year or so, we sell it for 450K.
So, which one will we (our LLC) be taxed in the following tax year on capital gains tax ?
a) 450K - 400K (original purchase price) + 15K (depreciation) = 65K Capital Gains
b) 450K - 1 (cost to LLC) = 499,999 capital gains
Before you deed your house to an LLC, you should consider the home sale exclusion (Section 121) if you are planning to sell the house in the near future.
You do not want to jeopardize the status such that you do not qualify for the exclusion from gain on a future sale of the property. Only disregarded entities potentially qualify for the exclusion and multi-member LLCs are not disregarded entities.
I feel like I'm piling on @tagteam, but a spousal LLC that holds rental property likely isn't a "business entity" for tax purposes, and likely can (protectively) elect out of the partnership regime under 761(a) or (f). So, yes, in some cases multimember LLCs can be disregarded as entities, which is like being a disregarded entity under the usual rules, and you can preserve 121 eligibility for any subsequent sale (which is important).
Whether you need the LLC protections in addition to insurance is a more a matter of taste. I don't think it's unreasonable to seek additional liability protection, but it's not as easy as holding the property as-is.
So, yes, in some cases multimember LLCs can be disregarded as entities, which is like being a disregarded entity under the usual rules, and you can preserve 121 eligibility for any subsequent sale (which is important).
Actually in NO case can a multi-member LLC be considered a disregarded entity for the purposes of the Section 121 exclusion. The Regs limit the exception (see below).
Treas. Reg. §1.121-1(c)(3)(ii) provides, in relevant part:
If a residence is owned by an eligible entity....that has a single owner and is disregarded for federal tax purposes as an entity separate from its owner.......the owner will be treated as owning the residence for purposes of satisfying the 2-year ownership requirement of section 121, and the sale or exchange by the entity will be treated as if made by the owner.
......and of course.... as I"m sure is expected.... here's my two cents on why it makes absolutely no sense to put rental property into an LLC of any type.
Additional Information For Rental Property Owners
Occasionally a rental property owner will be “convinced” they need to put their rental property into an LLC (be it single owner or multi-owner LLC) as a means of protecting themselves and their personal assets from legal litigation should they ever be sued by a tenant. The property owner is told the LLC gives them and their personal assets a “veil of protection” from any legal litigation that may arise as the result of legal actions perpetrated by a rental tenant. Nothing could be farther from the truth. If you check court records (even in your local area) you’ll probably find numerous cases where a tenant sued their landlord and the LLC provided practically no protection of the property owner’s assets. That “veil of protection” supposedly offered by an LLC is so thin, even a new first time lawyer has no problem piercing that veil and attacking the personal assets of the property owner on behalf of the tenant. There are other problems and issues with this too.
In order to legally transfer ownership of rental property to an LLC, the owner must have the permission of the mortgage holder. No lender in their right mind will give this permission either. Even if you think you can refinance the property or “sell” it to your LLC, unless your LLC has the cash on hand to pay for it in full, your LLC will never qualify for the mortgage loan. The lender doesn’t want to risk your LLC going under (by filing bankruptcy for example), and they lose money because of it. So I’m confident in telling you, that’s not going to happen.
When you create an LLC for your rental property, it’s generally understood that business income gets reported on SCH C as a part of your personal tax return. However, a SCH C business produces “earned” income, and a rental property produces “passive” income. What’s the difference?
Earned income is income which you have to do out and “do something” on a recurring basis in order to earn it. This income is subject to regular income tax, and also an additional 12.6% self-employment tax. The SE tax is basically the employer side of your social security and Medicare. But rental income is not “earned” income, and therefore is not reported on SCH C. So if you create an LLC for your rental property, then absolutely nothing concerning that rental property will be reported on SCH C. Not one penny of rental income and not one penny of rental expenses.
Rental income is “passive”. That’s because all you do with rental property on a recurring basis is just “sit there” and collect the rent every month. You are not “doing anything” to “earn” it on a recurring basis. That’s why rental income is reported on SCH E. Rental income is subject to regular tax, but is NOT subject to the additional self-employment tax. This means that rental income DOES NOT COUNT for your social security account or Medicare contributions.
SO if you create an LLC for your rental property, there are two things that will NOT happen.
- You will not be able to “legally” transfer ownership of the property from you, to the LLC unless you have a really dumb lender.
- You will not report one penny of rental income or one penny of rental expense on SCH C.
So in the end, you will be filing a zero income/expense SCH C with your personal tax return.
Now let’s say you decide to file the 2552 to treat your LLC like an S-Corp, and then you transfer ownership of the property to your LLC. You can and will report your rental income on SCH E as a part of the 1120-S Corporate Return, and you will also report the K-1 on SCH E as a part of your personal tax return. But keep in mind that this is for ***TAX PURPOSES ONLY!!!****. So if a tenant sues you, I seriously doubt the courts will recognize your S-Corp, and I seriously doubt the court will recognize the S-Corp as a physically separate owner of the property. Remember, that 2552 Entity Classification Election is for “TAX PURPOSES ONY”. It has no weight at all for any and all other legal purposes – such as you being sued by a tenant.
SO if you want to do this (and it still makes no financial sense) then form an actual S-Corp and transfer ownership of the property to the S-Corp. More than likely the lender won’t allow the transfer. But you can sell the property to the S-Corp if the S-Corp can qualify for a mortgage loan. Overall though, it’s still financially dumb to do this. Here’s why I say that.
When you move out of your primary residence and convert it to residential rental real estate, you have to convert your homeowner’s insurance policy to a rental dwelling policy. Or if you buy the real estate as rental property outright, then you have to obtain a rental dwelling policy at that time. A rental dwelling policy will, at a minimum, include $300,000 of liability coverage. For most that will suffice. But if the property is in certain areas of the country you may want more liability coverage. I have three rentals myself and have a total of $1,000,000 of liability on each. It cost me less than an additional $100 a year on the insurance for each property. So for me, it’s worth it. It’s also significantly cheaper not only in money, but in time spent dealing with corporate taxes and all that other additional paperwork crap.
One mistake I see quite often is that when an owner converts their primary residence or 2nd home to rental property, and they fail to update their insurance policy. This can bite when you have a claim. If the property is insured as your primary residence, but you are using it as rental property (which is other than it’s insured use) don’t be surprised when the insurance company denies your claim, and you can’t find any lawyers that will take your case. If it’s a case of you being sued by a tenant, then to be honest and put it bluntly, you’re screwed.
Uh, elections out of sub K mean that there is no "eligible entity" because there is no "business entity" for tax purposes. You must have a business entity to have an eligible entity. This all is in the 7701 regs referenced in the 121 regs cited by @tagteam.
Elections out result in co-ownership--the entity is disregarded, and the spouses are treated as direct owners for tax purposes--which isn't the same as a disregarded entity under the 7701 regs but has a similar effect. Co-ownership generally is contemplated under 121.
@Carl, I'm not sure the LLC changes whether rental activities are reported on Sch. C or E. Determining whether a rental rises to the level of a trade or business is independent of whether a state-law entity owns the property. If the services are minimal, then it's likely on Sch. E. If you're running a hotel, then you're probably on Sch. C regardless.
In terms of liability protection, I tend to agree that veil-piercing is a risk, and that lender consents likely are preclusive. But, again, it's a matter of taste, and the poster should seek appropriate advice to see whether an LLC makes sense for their specific situation.
@helpfuluser I'm not disagreeing with you at all. I'm just pointing out other potential legal issues outside of taxes that can be far more costly than not reporting things correctly on a tax return. One big factor is what state the LLC may be in and the laws of that specific state as they pertain to rental property (short or long term) and LLCs. While the laws of some states may afford the LLC a "veil of protection" that is better/higher than others, it just doesn't for many states.
I know in my state of FL, putting a rental into an LLC is probably the dumbest thing liability-wise a rental property owner could do. But still, there are one or two situations (concerning a multi-member LLC) where it's actually advantageous to do so. Bottom line is, seek professional help not only from a CPA or tax lawyer, but from another lawyer who is well versed in the legalities of liability and the such, which has nothing to do with taxes really.
A few years back I had links to about 10-12 cases in Miami, Ft. Lauderdale and Orlando where lawyers had no problem piercing that so-called "veil of protection" of an LLC in this state and the tenant basically wiped out or bankrupted the rental property owners on liability charges. One of the cases involved an insurance claim where the insurance company refused to pay for a total loss due to a fire accidently started by the tenant. The property owner had not updated their homeowner's policy to a Rental Dwelling policy. So since the property was not being used for it's insured purpose as the owner's primary residence at the time of the fire, the insurance would not pay. The property owner lost. On top of that, since the property was not insured that put the owner in violation of their mortgage lending agreement and they basically lost everything when the bank not only to th e land the burned down rental property was on, but they also won in court, the "new" primary residence they have moved into upon vacating their old residence and renting it out.
So when it comes to this rental property stuff, correct tax reporting is just the tip of the legal iceberg.