Holding Investment Real Estate: LLC, Trust or Both?

The Problem: How to Maintain Property in California?

Countless people invest in real estate every day. Some dream of becoming the next real estate mogul, while others simply want to supplement their salary with additional income. Whatever your motivations, owning investment property can yield big rewards, but also big problems. That is why it is important to have title to your property in the most beneficial way. The Internet is saturated with various publications and articles promoting the most effective techniques for managing your property. It can often be a daunting task to sift through the vast amount of information in an attempt to discern which tips are trustworthy and which tips may cause you trouble. Our goal here is to provide a succinct and clear summary of the safest and most important strategies for holding investment property in California. We hope the result will be a valuable starting point for considering the best ways to protect you as an owner/lessor from liability and also ensure the best treatment of your assets.

The risks of owning real estate

As stated above, while property can be a valuable investment, there are also significant risks. One of the biggest risks is lawsuits. From common slip and falls to environmental contamination, landlords and homeowners are easily exposed to legal lawsuits. Landlords have also been successfully sued by victims of crimes, such as robberies, rapes, and even murders, that occur on their property on the theory that the landlord provided inadequate security.

Options for real estate ownership

Faced with the risk of lawsuits, it is crucial that you do not own investment real estate in your own name. (The only real property you must have in your own name is your principal residence.) Fortunately, there are several ways in which a person can own property that is not in their own name. These include as a corporation, limited partnership, limited liability company (“LLC”), trust, and many others. While there are many options, when it comes to real estate investing, LLCs are the entity of choice for most investors, attorneys, and accountants.

For many reasons, few investors own investment real estate in C corporations. A corporation protects shareholders from personal liability, but the double taxation of dividends and the inability to have “paper losses” from depreciation flow to the owners make that a C corporation is unsuitable for real estate investments.

In the past, partnerships and limited partnerships were the entities of choice for real estate investors. Limited partners were protected from personal liability and at the same time could take past tax losses (subject to IRS rules: you will need an accountant or attorney to resolve limitations at risk issues, etc.) from the property. However, the biggest disadvantage of limited partnerships was that someone had to be the general partner and expose yourself to unlimited personal liability.

Many small real estate investors also hold properties in a trust. While a living trust is important in protecting the owner’s privacy and provides valuable estate planning treatment, the trust provides nothing in the area of ​​liability protection. However, while a trust does not provide liability protection, it should not be overlooked as it can easily be combined with an LLC.

1. Benefits of an LLC

LLCs seem to be the best of all worlds for investment real estate holdings. Unlike limited partnerships, LLCs do not require a general partner who is exposed to liability. Instead, all LLC owners, called members, have full limited liability protection. LLCs are also superior to C corporations because LLCs avoid the double taxation of corporations, but retain full limited liability for all members. Also, LLCs are fairly cheap and easy to form.

A. One LLC or multiple LLCs?

For owners of multiple properties, the question arises as to whether to keep all properties under one LLC or create a new LLC for each additional property. For various reasons, it is generally advisable to have an LLC for each property.

First, having a separate LLC that owns each property separately prevents the liability of “spillover” from one property to another. Suppose you have two properties worth $500,000 and they are in the same LLC. If a tenant is injured in Property 1 and wins a $750,000 judgment, he will be able to lien both properties for the entire $750,000 even if Property 2 had nothing to do with the plaintiff’s injury.

On the other hand, if each property had its own LLC, then the creditor would only be able to encumber the property where the plaintiff was injured (assuming they can’t lift the corporate veil).

Additionally, many banks and lenders require separate LLCs for each property. They want the property they are lending against to be “remote to bankruptcy.” This means that the lender does not want a problem on a separate property to jeopardize its security interest in the property on which it is lending.

2. Benefits of a Trust

As stated above, an LLC can be used at the same time as a trust to provide the best protection and estate treatment for your property. There are many types of trusts, but the revocable living trust is probably the most common and useful for maintaining title to property. The main benefit of having property in a trust is that the property prevents probate after your death. As many know, probate is a court-supervised process to transfer assets to the beneficiaries listed in the will. The advantages of avoiding probate are numerous. Distribution of assets in a living trust can be much faster than probate, assets in a living trust can be more easily accessible to the beneficiaries of the trust, and the cost of distributing assets in a living trust is often less than going through the sequence . [Note: One should also be aware of other ways to avoid probate. For instance, property held in joint tenancy with a right of survivorship automatically avoids probate whether or not the property is in the living trust. Consult an estate planning attorney for more advice regarding probate matters.]

3. Use both an LLC and a trust

Because both an LLC and a trust provide significant benefits to the real estate owner, a savvy investor should consider using both an LLC and a trust to adequately protect himself and his property. Using both a trust and an LLC creates the best combination of liability protection and favorable estate planning. To accomplish this, the owner must have investment property in a single member LLC, with the living trust as the sole member of the LLC. Here, the trust is the owner of the company and owns all of the interests of the LLC. This form of ownership gives you an extra layer of LLC protection, as well as the added estate planning benefits of a trust.

A. Costs

For the most part, the costs of forming and maintaining an LLC and trust are minimal. For the average LLC, the costs are simply nominal filing fees and an $800 per year fee to the state of CA. While simple incorporations can be done on your own, it is strongly recommended that you seek the advice of an experienced attorney so that no mistakes are made. The same can be said for the formation of a trust. A little money now is worth the price of avoiding big problems in the future.

B. The CA LLC Fee

While the costs of forming an LLC are generally small, there are additional fees that may be imposed on LLCs in California based on gross profits. California Revenue and Taxation Code Section 17942(a) includes an additional fee for LLCs if total gross income (ie, rent) exceeds $250,000. “Total Gross Income” means gross receipts (not earnings). Under this Section of the Tax Code, the amount of the fee is determined as follows:

1. $0 for LLCs with total gross receipts less than $250,000;
2. $900 for LLCs with total gross receipts of at least $250,000 but less than $500,000;
3. $2,500 for LLCs with total gross receipts of at least $500,000 but less than $1,000,000;
4. $6,000 for LLCs with total gross receipts of at least $1,000,000 but less than $5,000,000; Y
5. $11,790 for LLCs with total gross receipts of $5,000,000 or more.

While the fee is relatively small, keep in mind that the fee is assessed based on gross receipts, not profit. This means that the fee must be paid whether or not your property is profitable. For a property with high income but narrow profit margins, the rate would reflect a higher portion of the property’s profitability than a property that is highly profitable. For example, a business that owns an office building with rental income totaling $1 million, but a mortgage of $995,000, would actually be operating at a loss after the $6,000 fee is imposed. Furthermore, the fee would be particularly annoying for those companies that expect to incur losses in their early stages of development.

4. Limited Partnership – a possible strategy if gross receipts are over $250,000

For the vast majority of investors, the CA LLC fee should not deter you from forming an LLC. However, if the impact is severely detrimental, there are several potential solutions that can be explored. A competent attorney or accountant can work with you to avoid this fee. One method may be to form a limited partnership. The partnership must be established with an LLC as the general partner (assuming liability) and the property owners as limited partners. By forming a limited partnership with an LLC acting as general partner, the landlord can likely avoid the higher fee imposed on an LLC while protecting their personal liability. While this may be a possible solution, it is highly recommended that you consult with an attorney or accountant regarding the best course of action.

While there are risks associated with real estate, with smart decision-making and careful preparation, real estate can be a worthwhile investment. However, the first step is to make sure that you and your property have been adequately protected. We hope this article helps property owners begin to discover the many ways one can own an investment property, as well as the protections and benefits such property provides.