There are numerous reasons to own real estate, from tax benefits to portfolio diversification. However, you might also encounter some financial risks if you personally own the property. By transferring property to an LLC, you can give yourself liability protection, privacy, and tax flexibility.
Since you’ll still need to file a personal tax return, this move doesn’t affect your overall tax liability. However, it can trigger inevitable tax consequences, which include capital gains and transfer taxes. To limit your tax liabilities, it’s highly recommended that you seek professional advice from a CPA or accountant.
California’s property tax laws have changed considerably over the years. Updates to existing property transfer and tax laws are made regularly. Among the most significant changes was Proposition 19, which went into effect in April 2021.
This law eliminates the parent-child exclusion from tax reassessment for rental property transfers. Parents can now avoid tax reassessment when transferring rental property to their children. The rules of LLCs make it possible to avoid high property taxes. In this guide, you’ll discover the tax consequences of transferring property to an LLC.
Tax Consequences of Transferring Property to an LLC
While there are many advantages associated with transferring real estate to an LLC, there are also numerous tax implications you must consider. For example, you may receive a tax bill for your gains. If your rental property has increased in value by an ample amount and you end up transferring it to an LLC, it may trigger capital gains taxes. If you’ve used the depreciation tax break to reduce the value of your property over the years effectively, capital gains taxes are more likely. You could defer these taxes with a 1031 exchange.
If you received a rental property as a gift or as part of your inheritance, the tax basis likely rose to the property’s fair market value after you acquired it, which means that you have a higher value for depreciation. In this situation, you should benefit from lower taxes. However, if you transfer the property to an LLC, this advantage no longer applies to you. The basis reverts to the original price that the previous owner paid.
Your property tax payments can be impacted as well. When ownership switches from yourself to an LLC, the property might be reassessed at its fair market value instead of the previous taxable value. This reassessment could result in a higher assessed value, meaning your property tax bills would increase. The county recorder may also charge an assignment tax when ownership is transferred, which equates to 1-2% of the property’s value.
What is an LLC?
A Limited Liability Company (LLC) is a type of business entity that offers the benefits of a sole proprietorship and the advantages of a corporation. Real estate investors and small businesses often choose this legal structure because of its ample tax benefits and flexibility. For example, an LLC provides limited liability protection to each member. After creating an LLC, your assets will be kept separate from your legal liabilities and tax debts.
If you own one or more rental properties, transferring them to an LLC allows you to shield your assets from liabilities and deduct your losses on your next tax return.
Proposition 19 and Changes in California
California’s Proposition 19 was initially passed in 2020. As mentioned previously, this law placed limitations on property transfers. Before the law was passed, parents could transfer real estate to their children without triggering a property tax reassessment. Now, parents can only transfer their primary residence to a child. There’s also a limit of $1 million that can be excluded from tax reassessment.
The issue with these changes is that many California properties are worth well over $1 million, which makes it more difficult for children to hold onto rental properties that are reassessed to their fair market value. Since taxes are so high, people are forced to sell their inherited properties even when they don’t want to. Inheritances are no longer as valuable as they once were.
To avoid property tax reassessment, you must employ alternative strategies, primarily transferring real estate to an LLC. Several different techniques can be used to make this transfer, all of which require planning.
Strategies for Transferring Property to an LLC
The strategy you use to transfer property to an LLC depends on your specific situation and desired ownership structure.
Legal Entity Exclusion
A legal entity exclusion strategy allows the transfer of 50% or less of the property without triggering a reassessment. You can create a new legal entity without changing ownership. If you own the LLC and transfer 50% of your interest in the property to another entity, you should be able to avoid a reassessment.
Proportional Interest Exclusion
You can also avoid reassessment with the proportional interest exclusion. With this strategy, you’ll be tasked with transferring property to or from a legal entity with proportional interests. Ensure that you and the legal entity have the same ownership interests in the property.
Let’s say you and your spouse own 50/50 property. If you transfer this proportional ownership to an LLC, a reassessment won’t occur. Work closely with an attorney to ensure compliance with this exclusion.
Joint Tenancy Strategy
Joint tenancy is a typical legal structure with an “original transferor” rule. This rule states that reassessment can be delayed if one joint tenant dies but the other survives. However, the tenant who survives must be an original transferor. If both original transferors are part of the new structure, you can take advantage of this exclusion when transferring real estate to an LLC. This strategy has limited uses in business properties and is most often applied to revocable trusts.
Benefits of Transferring Real Estate to an LLC
Transferring real estate to an LLC offers many advantages, including liability protection and tax efficiency.
Liability Protection
An LLC shields all your assets from foreclosures and legal judgments, so investors and property owners choose this structure. Your assets don’t become part of your business, so they are protected. If a tenant or contractor wins a legal judgment against you, it won’t impact your assets. If the property you place inside the LLC is about to be foreclosed on, it’s the only one that can be seized if you default.
Tax Efficiency
You’ll also benefit from better tax efficiency with pass-through taxation and filing flexibility. Pass-through taxation means that any profits or losses from the LLC only apply to your tax returns. You don’t need to pay a corporate tax.
You should also be able to deduct your rental property losses against the sources of income that you list on your tax return. Transferring real estate to an LLC can shield these assets from a personal IRS tax lien.
Creditor Protection and Privacy
Any assets you own in an LLC are shielded from financial lawsuits against you. Creditors can’t touch your assets, so your real estate will be protected. You’ll also have a certain amount of privacy. Public records for LLC ownership don’t display personal details.
Costs and Considerations
Several costs and considerations might be taken into account before transferring property to an LLC. For example, California has an LLC formation fee of $70. They also charge annual fees that you’ll need to pay as long as you maintain the LLC, amounting to $800.
The tax paperwork for an LLC is more complex than what you encounter with personal filings, so hiring a tax professional or CPA is a good idea. However, hiring a professional costs money and adds to your expenses. You’ll also spend administrative time completing annual filings, financial statements, and record-keeping. Thorough documentation is essential for maintaining your liability protection.
Steps to Transfer Property to an LLC
You can create an LLC in seven simple steps. First, choose an LLC name. Make sure it’s short and professional. You’ll also need to search the name at the Secretary of State’s office to ensure it’s still available. After choosing a name, you can file articles about the organization to create the LLC officially.
Your next step involves obtaining an employer identification number (EIN), essential for handling taxes. When you report income or expenses with the LLC, you’ll need to use your tax ID number, which you can get from the IRS.
Open a bank account in the company’s name, which you can do with your EIN. If you want to maintain liability protection, don’t place any personal assets in this account. Record a new deed to transfer the property to the LLC. Work directly with the county recorder’s office to obtain a warranty or quitclaim deed.
Notify your mortgage lender and any other stakeholders about the transfer. To proceed with this process, you’ll need to sign an assumption agreement. The LLC should be updated with details about all stakeholders in the property, including tenants, utility companies, and insurance providers.
If you have permits, registrations, or licenses with your rental property, they may need to be updated to reflect the LLC ownership. To avoid any issues with the LLC, speak with an accountant about different tax considerations that apply to you. These considerations include everything from depreciation to capital gains taxes.
Comply with all ongoing LLC requirements, maintain proper records, pay your annual fees, and keep your business and personal assets separate.
Conclusion
Transferring real estate to an LLC helps you avoid tax reassessments that lead to high property taxes. Since Proposition 19 is law, transferring property to an LLC is a highly effective strategy. However, you’ll need to consider some tax consequences and limitations to ensure you only pay what you have to. You must seek professional guidance when making any property transfer. If you take the right approach with an LLC transfer, you can benefit from ample tax savings.