Single-member limited liability companies (SMLLCs) are limited liability companies (LLCs) with only one member (owner). As with a corporation, operating your business or investment activity as an LLC generally protects your personal assets from exposure to liabilities related to the activity — under applicable state law.
As a bonus, SMLLCs also offer some unique tax attributes that make them ideal real estate ownership vehicles. Here’s the story.
Advantage: disregarded SMLLCs are ignored for federal income tax purposes
Under IRS regulations, the existence of an SMLLC is generally ignored for federal income tax purposes. In other words, the SMLLC is a so-called disregarded entity under the tax rules.
The federal income tax treatment of a disregarded SMLLC is super-simple: its activities are considered to be conducted directly by the SMLLC’s sole member (owner). When an individual (like you) uses a disregarded SMLLC to own rental real estate, the federal income tax results are reported on your Form 1040 in the same fashion as if you directly owned the property. You need not file a separate federal income tax return for the SMLLC. This is easy.
Advantage: disregarded SMLLCs are separate legal entities under state law
Here’s where it starts to get interesting.
Although disregarded SMLLCs are ignored for federal income tax purposes, they are not ignored for state-law purposes. Therefore:
* A disregarded SMLLC will deliver to its member (you) the liability protection benefits specified by the applicable state LLC statute. These liability protection benefits are usually similar to those provided by a corporation. That means a disregarded SMLLC can help protect your personal assets from exposure to liabilities related the SMLLC’s activities.
The preceding happy set of tax and legal circumstances for disregarded SMLLCs opens up some nice planning opportunities in the real estate arena. Please keep reading.
SMLLC can provide liability protection for you as a real estate investor
You as a real estate investor are rightly concerned about exposure to all the various and sundry liabilities that property ownership can entail. These can range from environmental liabilities to personal injury claims when tenants or visitors slip and fall on icy sidewalks.
Setting up a disregarded SMLLC to own real estate addresses the liability exposure problem without adding any tax complexity.
If you use an SMLLC to own real estate, you will probably have to personally guarantee any mortgages against the property, but that’s par for the course in the real estate world.
SMLLC preserves your eligibility to make tax-favored Section 1031 exchanges of real estate
Here’s where it gets even more interesting. The disregarded SMLLC’s member (you) is considered to directly own for federal income tax purposes any asset that is actually owned by the disregarded SMLLC.
Therefore, if you use the SMLLC to own real property and then want to swap the property in a tax-favored Section 1031 exchange, the exchange will be treated as an exchange by you personally.
Under the Section 1031 exchange rules, you can potentially swap appreciated real estate for a replacement property (or properties) while owing little or nothing to Uncle Sam. Meanwhile, the relinquished property that you give up in the exchange and the replacement property (or properties) received in the exchange can at all times be held within the liability-limiting confines of the SMLLC. Great. If you are the skeptical type, please be assured that the IRS has repeatedly confirmed this taxpayer-friendly conclusion.
If the property that you will relinquish in an upcoming like-kind exchange is currently owned directly by you as an individual, you can set up a new disregarded SMLLC to receive the replacement property. The swap can still qualify for tax-favored Section 1031 exchange treatment, because both the relinquished and replacement properties are considered to be owned directly by you as an individual for federal income tax purposes. However under applicable state law, the SMLLC will help protect you from liabilities associated with the replacement property, because you personally will never appear in the chain of title.
Don’t overlook state and local tax implications
While disregarded SMLLCs work great as real estate ownership vehicles under the federal income tax rules, there might be state and local tax considerations. For example, Texas SMLLCs with incomes above certain levels must pay the state’s franchise tax (similar to a corporate income tax). Fortunately, the tax will not be a big number in most cases.
Even if a disregarded SMLLC is not required to pay any state income tax (the most common situation), it may still have to pay an annual registration fee and file some paperwork. Cost of doing business.
Also keep in mind: Section 1031 exchanges now only allowed for real property
Thanks to the Tax Cuts and Jobs Act that became law at the end of 2017, tax-favored Section 1031 exchange treatment is now only allowed for qualifying swaps of real estate (no more Section 1031 treatment for swaps of personal property assets). Properly structured exchanges of real estate are unaffected by this change.
The bottom line
You now understand the liability protection and federal income tax advantages of using a disregarded SMLLC as a real estate ownership vehicle. Even so, please consult a tax pro and real estate attorney before taking any action. You need to understand exactly what you are getting into.
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