Investing in Real Estate? Looking to cash out? Helpful tips on 1031 Exchanges and Structuring with an LLC
IRS Section 1031:Thanks to IRC Section 1031, a properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
To understand the powerful protection a 1031 exchange offers, consider the following example:
Assume an investor has $400,000 in gain and also $400,000 in net proceeds after closing. Assuming an investor with a $400,000 capital gain and incurs a tax liability of approximately $140,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. Only $260,000 in net equity remains to reinvest in another property.
Assuming a 25% down payment and taking on new financing for the purchase with a 75% loan-to-value ratio, the investor would only be able to purchase a $1,040,000 replacement property.
If the same investor chose to exchange, however, he or she would be able to reinvest the entire gross equity of $400,000 in the purchase of $1,600,000 replacement property, assuming the same down payment and loan-to-value ratios.
As the above example demonstrates, tax-deferred exchanges allow investors to defer capital gain taxes as well as facilitate significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the Section 1031 code. For instance, an accurate understanding of the key term like-kind – often mistakenly thought to mean the same exact types of property – can reveal possibilities that might have been dismissed or overlooked.
Helpful calculator: IRS 1031
Business Structuring: To be LLC , or not to be.
What is an LLC?
A limited liability company (LLC) is a business structure. You can create an LLC by yourself, with a partner, or with a group. If you own an LLC you are a “member” of the LLC.
LLC’s are regulated at the state level, so the process of creating an LLC will differ state-by-state. This article will provide an overview of benefits of creating an LLC and how to create an LLC. We strongly recommend doing state-specific research to further understand how to create an LLC in your state (and the specific fees and costs).
What are the Benefits of Creating an LLC?
There are four benefits of creating an LLC for your rental property.
Limit Your Personal Liability
If you own your property as an individual and someone files a lawsuit against you, then your personal assets are at stake. However, if you create an LLC, then the only assets at stake are those owned by the LLC. In other words, your rental property is the only asset at stake and not your personal finances.
Keep Your Rental Properties Separate From Each Other
In addition to separating the rental property from your personal assets, you should also separate your rental properties from each other. If you own multiple properties, you can “insulate” each property from liability claims by setting up separate LLCs for each property. If you have all of your properties under separate LLCs, then if someone files a lawsuit pertaining to one of your properties, then the rest of your properties will not be affected by the lawsuit. This effectively separates and protects each of your properties.
Pass-through taxation is a benefit of individual-owned businesses. Normally, a corporation is taxed directly on its profits and owners are taxed again when they make income from their business. With an LLC, you get the benefit of the company’s income “passing through” to you as the business owner. Essentially, all income made by your LLC (your rental property) will flow through to your individual income tax return. This minimizes the amount of money taken out of your income for taxes.
Easily Separate Business and Personal Expenses
When you create an LLC, you should create a separate bank account for your LLC. That way, your personal expenses are separated from business expenses.
This makes it easier to claim business expenses when it comes time to do your taxes. It will be visually clear to you when you check your bank statements which expenses are business and personal.
Who Should Create an LLC?
Any landlord can benefit from creating an LLC. Whether you have one property or several, you will benefit from pass-through taxation and protecting your personal liability.
LLCs can be especially helpful if there are multiple owners of a property. When you create an LLC, you’ll create an operating agreement that outlines the rights and responsibilities of each member of the LLC. This can help you seamlessly manage the property and protect each member of the LLC in case of legal trouble.
When Should You Create an LLC?
You may be wondering if you should create an LLC before or after you buy a rental property. The good news is that either way, you’ll be able to transfer ownership of your property to the LLC. However, it’s better to create an LLC before you buy a rental property so you avoid the following headaches:
If you already own a rental property and want to create an LLC, you’ll need to transfer the deed for the property to the LLC. This is also commonly called a “transfer title.” See our answer below for more on how to transfer title to the LLC, what a property title is, and what a property deed is.
How Do You Transfer Title to the LLC?
First, let’s define some legal terms. In property law, property title is a bundle of rights that outline ownership of a property. These rights can be held by several parties or by a single individual. Titles can also refer to a formal document known as a property deed that serves as evidence of ownership. Your property deed is a legal document that states who owns the property.
If you bought the property as an individual, then the property deed will state your name. This means you are personally liable if any claims are brought against the property. The benefit of creating an LLC is that you don’t need to have your name on the property deed. Your LLC’s name should be on the deed.
In order to “transfer title” to the LLC, which means to transfer ownership rights to the LLC, you need to create a Quit Claim Deed and file it at your local County Clerk’s office. Quit Claim Deeds allow you to edit information on previously recorded deeds.
You can create a Quit Claim Deed by contacting a real estate lawyer or you can use a service like Rocket Lawyer to create one for free.
Be aware that there is sometimes a title transfer tax, which charges you for the privilege of transferring title.
Does Creating an LLC Impact Your Financing?
If you have an existing mortgage when you transfer your property into an LLC, then it may affect your financing.
If you transfer title to your LLC but have a mortgage in your individual name, then the name on your mortgage note will not match the name on your property deed. This likely compromises the foreclosure rights of your lender. For this reason, we recommend contacting your lender to find out if they allow you to transfer title to the LLC.
This should be the first step to take if you are interested in creating an LLC. See our steps below for a complete outline of steps to take.
If your lender allows you to transfer title despite an existing mortgage, then find out what conditions they may have. Some lenders allow you to transfer title, but will increase your interest rate, charge an assumption fee, or have other requirements.
How Do I Create an LLC?
Below are ten steps to help you create your LLC:
What is the Cost of Creating an LLC?
The cost of creating an LLC will differ state-by-state. Below are possible costs associated with creating an LLC: (NYS has significantly higher Notice of Intent costs)
Are There Ongoing Costs Once You Create an LLC?
Below are two possible ongoing costs once you create an LLC:
Keep in mind that transferring ownership to your LLC may trigger tax consequences depending on the value of your property when you transfer title. This is because the value of your property may have increased from the time you bought the property. These additional tax consequences can be avoided by creating an LLC before you buy the property.
How Do You Name the LLC for Your Rental Property?
You can name your LLC anything you want, as long as it’s not a name already registered in your state and it’s appropriate for your rental business.
Most landlords use their property address to name their LLC. For example, “123 Main Street Chicago LLC.” There are two benefits of naming your LLC this way. For one, it’s easily recognizable to your tenants. Second, it’s likely a unique address in your city or county, meaning you’ll be able to register it without a problem.
You can check if an LLC name is available by searching your Secretary of State’s webpage. There are also many services available online that allow you to search the availability of business names.
What Are the Pros and Cons of Creating an LLC?
Does an Umbrella Policy Offer the Same Protection as an LLC?
Landlords often try to mimic the liability protection of an LLC with insurance, specifically with an umbrella policy. An umbrella policycan help cover costs that go above your standard insurance policy. For example, let’s say your insurance covers damages and lawsuits up to $250,000 dollars, but you’re sued for $1 million. Your standard policy would not be sufficient and your personal assets would be at stake for the remaining balance. However, if you purchase an umbrella policy, it would help cover the remaining balance, adding more protection for your personal assets.
That being said, your umbrella policy will still have a limit. Your personal assets will be vulnerable if the lawsuit exceeds the umbrella policy’s coverage amount. Creating an LLC is a more effective way to protect your personal assets so they are never vulnerable during a lawsuit. Despite the additional work and costs of creating an LLC, this added protection is often worth it for landlords.
Creating an LLC for your rental property is a smart choice as a property owner. It reduces your liability risk, effectively separates your assets, and has the tax benefit of pass-through taxation.
If you decide to create an LLC for your rental property, make sure you update your rental leases. You’ll list the LLC as the property owner. And be sure to separate personal money from rental property money. For example, all rent payments should be stored in your LLC’s bank account.
Any further questions please contact us!