1. Protecting Against Liabilities Generated By the Real Estate.
Today, because of concerns over liability protection (and also in order to generate valuation discounts for estate and gift tax transfer purposes), clients will have real estate (other than their personal residence) owned in a legal entity, such as a limited partnership or limited liability company.
Examples of potential liabilities which real estate could generate would be: hazardous materials; slip-and-fall cases; disgruntled tenant claims; claims regarding mold; claims from the structural collapse of the real estate such as in an earthquake; claims by vendors and contractors; accounts payable; claims by tenants and tenant claims regarding security deposits; claims regarding recourse promissory notes secured by deeds of trust on the property; and claims based upon construction defects.
Clients who feel that they can protect themselves against claims by purchasing insurance must realize that when they sell their real estate they may cease being an insured under the real property’s liability insurance policy, and thus no longer have liability insurance coverage for future claims (as an example hazardous materials claims are not covered under regular liability insurance policies).
It is advisable for clients who own portfolios of real estate to split their properties among multiple limited liability companies in order to not have “all of their real estate in one basket” if a liability is generated by one of the real properties.
2. What Form of Legal Entity Should Own the Real Estate?
A C corporation should be avoided as an owner of real estate since there will be a 35 percent maximum Federal income tax, plus California corporate income tax at 8.84 percent.
An S corporation doing business in California, although not having a Federal-level income tax on its earnings, will still be subject to the 1-1/2 percent California tax on its earnings. Additionally, with an S corporation the shareholders do not get a step up in their stock’s income tax basis for corporate debt. This lack of a step up in an S corporation shares’ tax basis could cause unexpected capital gains to the shareholders upon distribution of real estate refinancing proceeds or other distributions from the corporation. Accordingly, for clients desiring liability protection, a limited liability company should be utilized to own real estate.
A limited liability company produces limited liability for all of its members. For limited liability companies owning real estate in California or operating in California, there is a gross receipts fee imposed on the limited liability company.
3. Use of Revocable Living Trusts to Own the Real Estate or to Own Interests of Legal Entities That Own Real Estate.
In order to avoid probate, clients may choose to transfer their assets into a revocable living trust. Clients can transfer title to their real estate directly into a revocable living trust, or for liability protection purposes may choose to first transfer their real estate to a limited liability company, followed by transferring these entity interests into a revocable living trust.
A revocable living trust not only serves to avoid having the real property go through the probate process (with its time consumption and costs), but also serves to protect the privacy of the client.
Real estate is transferred to a revocable living trust by executing a deed (either a grant deed or quitclaim deed). Care must be taken to obtain deeds of both spouses on deeds into a revocable living trust (even if the spouse is not named on the deed, since he or she may have a community property interest in that real estate).
4. No Prop 13 Reassessment of Real Estate’s Transfer to a Revocable Living Trust For California Property Tax Purposes.
Transfers to a revocable living trust (or from a revocable living trust back to the trustors) is excluded from being a change of ownership under Section 62 of the California Revenue and Taxation Code. Additionally, upon the death of the first-to-die spouse, when the real estate is allocated to an irrevocable trust (such as a QTIP trust or a bypass trust) where the surviving spouse is the sole income beneficiary, that trust qualifies for the exemption from being a change of ownership for property tax purposes.
5. The LLC Allows Transferring of “Hard to Split Up Real Estate” to Children and Other Family Members.
Generally, real estate cannot easily be split as separate tenant-in-common interests among family members. Thus, an LLC avoids having to gift fractional interests in such real estate to family members. Where family members directly own real estate fractional interests as tenants-incommon problems can occur with a family member’s death, divorce, or bankruptcy, or if there are creditor claims against the family member. Minor children owning real estate fractional interests can create title and legal authority problems on the sale of those real estate fractional interests. On the other hand, an LLC allows multiple ownership of real estate by family members, while avoiding these issues.
However, if there is a change in the majority ownership of the LLC that owns real property when it is transferred to children or other family members, that may be deemed a “change of ownership” under Prop 13 and the property owned by the LLC could be subject to reassessment even though title remains in the name of the LLC. For a detailed discussion, see our article, “Are Your Children Inheriting Real Property? – How to Avoid Prop 13 Tax Reassessment”.
6. The LLC Provides Protection in the Event of a Child’s Divorce.
The LLC provides protection should a family member’s marriage dissolve. Through gifts and purchases, the LLC membership interests can be characterized as the sole and separate property of married children. It is difficult for a child to commingle the child’s separate property LLC membership interests with the child’s community property. On the other hand, if real estate is owned directly by the child (rather than in a LLC), there is a greater likelihood allegations that the real estate was transmuted in whole or in part community property, and there is also a greater likelihood that the child’s spouse will make a claim against real estate owned outright by a child in the event of a divorce.
7. The LLC Provides the Opportunity to Train Other Family Members to Manage the Family’s Real Estate Affairs.
The LLC offers the opportunity to train other family members to manage the LLC’s real estate by training children and grandchildren in the LLC’s real estate operations, and slowly bringing these other family members into working for the LLC.