You’ve done it; you’ve taken all the necessary steps and purchased a home that you are planning to move into. At this stage of the process, you may think that your work is done, but the reality is that it is just beginning. With the deed to the property in your hand, you’ll be faced with taxes amongst other expensive challenges. Naturally, you’ll start looking into ways to save on these taxes, which is where an LLC may come up.
A question that is asked often is “can I put my primary residence in an LLC?” Many people are aware of the benefits that can come with holding real estate under a limited liability company and are curious about how they can implement this for their own home. Some of these benefits include liability protection for assets and significant tax advantages that cannot be ignored. Why not register your home under an LLC to get all these benefits?
The problem is that an LLC might not be the right choice for a property you currently live in. There are several caveats to this type of structure that you should be aware of, which is why it’s better to use an LLC for business investment rather than a primary residence:
What Is An LLC?
LLC’s are one of the simplest ways to structure a business in a way that protects assets in case of legal issues. The protection offered by an LLC is similar to that offered by corporations, but without actually being a cooperative entity. An LLC can be made up of a single individual, or several people then referred to as LLC members, with management being specified in the agreement. This LLC can then do business in multiple states although it must be registered and pay annual registration fees in its state of original registration. Upon formation, the members of the LLC can contribute cash, property, shares, or services and they can take out loans in the name of the LLC as well.
There are multiple reasons why people choose to structure an LLC: there is limited personal liability, less paperwork to oversee, more management flexibility, and tax benefits to name just a few. In real estate, LLC’s can be particularly useful. LLC’s with individual membership are taxed as sole proprietorship which comes with tax advantages like lower marginal tax brackets.
Another reason why this legal structure is popular with real estate investors is that they can register an LLC for each owned-property, preventing cross-liability. It’s also relatively easy to get an LLC registered in many states compared to other types of business structures, which is why this structure is more commonly used by real estate investors. Ultimately, the purpose of an LLC is to legally separate yourself from your business investments, which does not really apply to your primary residence.
Why Not Register An LLC For Your Home?
The same characteristics that make an LLC a good idea for real estate investing as a business are the ones that make it bad for your home. There are several good reasons why an LLC is not suitable for your primary residence. To start, there are more downsides to contend with financially. If your state has homestead exemption on property taxes, then putting your home under an LLC will mean you will not qualify. At present, the primary residence exemption is $250,000 for an individual and $500,000 for a married couple filing jointly. This exemption is only valid if you have spent two out of the last five years living in the property.
Similarly, creating an LLC around your primary residence can affect the type of financing you will be able to get, as well as the size of the down-payment you have to put down. If you plan to take out loans against the property under the LLC umbrella, you may run into difficulty with lenders because it is a primary residence. As the property is owned by an LLC, you might have to pay higher loan closing costs and be liable for higher interest rates.
Not only will an LLC affect your financing in this case, but it will also increase the amount of tax you are liable for. For local property tax and state income tax purposes, the deductions that would have been available to you as an individual owner are lost. Many local governments do not provide tax breaks to real estate corporations and businesses. In other words, an LLC doesn’t offer the tax benefit that most people are looking for, when they consider putting their personal residence in an LLC.
Adding to that, registering an LLC for your home will drive up your insurance cost as well. This is because by residing in the property, you effectively become a ‘tenant’ of the LLC which requires additional insurance to be taken out, or should an unexpected injury take place there, your property could be at risk.
The tax issues you will face living in an LLC-owned home are even further-reaching. With your primary residence placed under an LLC, you lose your capital gains deduction due to how the property ownership changes under the IRS.
Perhaps the most serious disadvantage when putting personal residence in LLC is related to any loans you may have taken on the property. Once you register as an LLC and the property ownership is transferred to it, you could trigger the “due on sale” clause found in loan documents that will cause the entire balance of the loan you took out to be payable immediately. Very few investors and property owners have the funds available to settle a balance this substantial in one go, and this is a real risk if you decide to put your home under this legal structure.
It’s also important to note that with your home and your business assets lumped together under the LLC umbrella, there is no barrier of asset protection between them. Any legal trouble you run into as an LLC would directly affect your home, which is a huge risk to take simply to save on taxes.
If the LLC is registered with multiple members including yourself, such as if your spouse took part in it, and you are not paying rent for your residence, it could constitute self-dealing and be a breach of fiduciary duty. This leads to the type of legal liability that you can ill-afford.
What LLC’s Should Be Used For
With all that said, what are LLC’s best to use for? While putting personal residence in LLC is not a good idea, there are some types of real estate investing that are perfect for this type of legal structure.
LLC’s are most suited to fix and flips – properties that are bought by investors for the purpose of renovation and resale in order to achieve capital gain. These properties are bought solely for business goals, and the investor does not have any intentions of moving in. This type of legal incorporation is ideal for flipping houses, as the investor’s personal assets are kept separate from those of the business. LLC’s are also relatively affordable to register, and the process can be done online. The other reason this structure is popular is because of how easy it is to transfer ownership.
Many rental real estate investors also place their rental properties under the protection of an LLC. Investment property can come with high liability if the landlord does not take the necessary precautions. The benefits of putting investment property under the liability protection of an LLC are very similar to the benefits that a fix and flip real estate investor can gain.
Another alternative with a similar structure is an S Corporation (S-Corp), also used as a strategy for asset protection. The main difference between an S-Corp and an LLC is in the way the taxes work: S-Corps are classified differently to LLC’s by the IRS . The income generated from an LLC is taxed as personal income, while business expenses in S-Corps are deducted from the company’s income. An S-Corp can offer the same level of asset protection, regardless of whether you focus on flipping houses or acquiring rental property.
The Better Option For Primary Residences
If an LLC is not a good option for your home, what can you do to protect it and save on federal taxes?
A more suitable option for a primary residence is to register it under a Qualified Personal Residence Trust (also known as QPRT). This is a type of trust that removes the personal home from your estate for the purposes of reducing gift tax when transferring the asset to a beneficiary of the trust. The great thing about this option is that it allows you to stay in the property for the terms of the trust without having to pay some sort of rent for it.
By allowing you to remain as a resident of the property for some time with “retained interest” in the house, a QPRT reduces your total taxable estate as well as gift liability tax should you decide to leave your home to someone else. You can set this out in the terms of the trust, creating allotments that state once the terms of the trust have come to an end, the remaining interest is transferred to beneficiaries. The biggest risk here is in determining the length of the trust agreement – you do not want to create terms that are too short and put you out of the property before you are ready.
It’s important to bear in mind that a QPRT is an irrevocable trust. Once the terms have been established and agreed to, it is not possible to change them or cancel it. You will also need to live in the property for a set amount of time or else you will lose the qualification.
Structuring your real estate investment under an LLC is a great way to get personal liability protection and save on taxes. However, it’s not suitable for primary residences – the benefits that you expect from an LLC don’t necessarily apply to your home, and an LLC, in this case, could cause you to incur more financial costs than it would lead to savings. There are several serious challenges that you will run into if you plan to place your home under this structure, from forfeiting tax benefits to triggering loan amounts to be due immediately. These are not risks that you want to take with your primary residence.
A QPRT is a better alternative for your personal residence, while LLC’s are more suitable to fix and flips and other non-primary residence real estate investments like rental properties. A QPRT can help you save on federal taxes, allow you to stay in the property without having to pay rent for it and is a good option if you plan on one day leaving your home to a loved one.