The problem: How to keep property in California?
Countless people invest in real estate every day. Some dream of becoming the next real estate tycoon, while others simply want to supplement their salary with additional income. Whatever your motivations, owning investment property can bring big rewards, but also big trouble. This is why it is important to have title to your property in the most beneficial way. The internet is saturated with various posts and articles promoting the most effective techniques for managing your property. It can often be a daunting task to sift through the vast amount of information in an attempt to discern which advice is trustworthy and which advice may get you into trouble. Our goal here is to provide a succinct and clear summary of the safest and most important strategies for maintaining investment property in California. We hope that the result will be a valuable starting point for considering the best ways to protect you as an owner/lessor from liability and also ensure the best treatment of your assets.
The risks of owning real estate
As stated above, while property can be a valuable investment, there are also significant risks. One of the biggest risks is lawsuits. From common slip and falls to environmental contamination, landlords and owners are easily exposed to lawsuits. Landlords have also been successfully sued by victims of crimes, such as robberies, rapes, and even murders, that occur on their property on the theory that the landlord provided inadequate security.
Real Estate Ownership Options
Faced with the risk of lawsuits, it is crucial that you do not own investment real estate in your own name. (The only real property you must have in your own name is your primary residence.) Fortunately, there are several ways a person can own property that is not in their own name. These include as a corporation, limited partnership, limited liability company (“LLC”), trust, and many others. While there are many options, when it comes to real estate investments, LLCs are the entity of choice for most investors, attorneys, and accountants.
For many reasons, few investors hold investment real estate in C corporations. A corporation protects shareholders from personal liability, but the double taxation of dividends and the inability to have “paper losses” from depreciation flow to the owners make that a C corporation is inappropriate for real estate investments.
In the past, partnerships and limited partnerships were the entities of choice for real estate investors. Limited partners were protected from personal liability while also being able to take past tax losses (subject to IRS rules: you’ll need an accountant or attorney to work out limitations at risk issues, etc.) from the property. However, the biggest disadvantage of limited partnerships was that someone had to be the general partner and expose themselves to unlimited personal liability.
Many small real estate investors also hold properties in a trust. While a living trust is important in protecting the owner’s privacy and provides valuable estate planning treatment, the living trust does not provide anything in the area of liability protection. However, while a trust does not provide liability protection, it should not be overlooked as it can easily be combined with an LLC.
1. Benefits of an LLC
LLCs seem to be the best of all worlds for owning investment real estate. Unlike limited partnerships, LLCs do not require a general partner who is exposed to liability. Instead, all LLC owners, called members, have full limited liability protection. LLCs are also superior to C corporations because LLCs avoid corporate double taxation, but retain full limited liability for all members. Also, LLCs are quite cheap and easy to form.
A. One LLC or multiple LLCs?
For owners of multiple properties, the question arises whether to keep all the properties under one LLC or create a new LLC for each additional property. For various reasons, it is generally advisable to have an LLC for each property.
First, having a separate LLC that owns each property separately avoids “spill over” liability from one property to another. Suppose you have two properties worth $500,000 and they are in the same LLC. If a tenant is injured on property 1 and wins a $750,000 judgment, he or she will be able to encumber both properties for the full $750,000 even if property 2 had nothing to do with the plaintiff’s injury.
On the other hand, if each property had its own LLC, then the creditor would only be able to encumber the property where the plaintiff was injured (assuming they can’t pierce the corporate veil).
Also, many banks and lenders require separate LLCs for each property. They want the property they are lending against to be “remote from bankruptcy.” This means that the lender does not want a separate property problem to jeopardize its security interest in the property on which it is lending.
2. Benefits of a trust
As stated above, an LLC can be used at the same time as a trust to provide the best protection and estate treatment for your property. There are many types of trusts, but the revocable living trust is probably the most common and useful for holding title to property. The main benefit of having assets in a trust is that the assets avoid probate after your death. As many know, probate is a court-supervised process for transferring assets to beneficiaries listed in the will. The advantages of avoiding succession are numerous. Distribution of assets in a living trust can be much quicker than probate, assets in a living trust can be more easily accessible to the beneficiaries of the trust, and the cost of distributing assets in a living trust is often less than going through the sequence . [Note: One should also be aware of other ways to avoid probate. For instance, property held in joint tenancy with a right of survivorship automatically avoids probate whether or not the property is in the living trust. Consult an estate planning attorney for more advice regarding probate matters.]
3. Use both an LLC and a trust
Because both an LLC and a trust provide significant benefits to the real estate owner, a savvy investor should consider using both an LLC and a trust to adequately protect himself and his property. Using both a trust and an LLC creates the best combination of liability protection and favorable estate planning. To accomplish this, the owner must have investment property in a single-member LLC, with the living trust as the sole member of the LLC. Here, the trust owns the business and owns all the interests in the LLC. This form of ownership gives you an added layer of protection from the LLC, as well as the added estate planning benefits of a trust.
A. Costs
For the most part, the costs of forming and maintaining an LLC and trust are minimal. For an average LLC, the costs are simply nominal filing fees and an $800 per year fee to the state of CA. While simple incorporations can be done on your own, it is strongly recommended that you seek the advice of an experienced attorney so that no mistakes are made. The same can be said for the formation of a trust. A little money now is worth the price of avoiding big problems later.
B. The CA LLC Fee
While the costs of forming an LLC are generally small, there are additional fees that may be imposed on LLCs in California based on gross profits. California Revenue and Taxation Code Section 17942(a) includes an additional fee on LLCs if the total gross income (ie rent) exceeds $250,000. “Total gross income” refers to gross income (not earnings). Under this Section of the Tax Code, the amount of the fee is determined as follows:
1. $0 for LLC with total gross receipts less than $250,000;
2. $900 for LLCs with total gross receipts of at least $250,000 but less than $500,000;
3. $2,500 for LLCs with total gross receipts of at least $500,000 but less than $1,000,000;
4. $6,000 for LLCs with total gross receipts of at least $1,000,000 but less than $5,000,000; Y
5. $11,790 for LLCs with total gross receipts of $5,000,000 or more.
While the fee is relatively small, it should be noted that the fee is assessed based on gross receipts, not earnings. This means that the fee must be paid whether or not your property is profitable. For a property with high incomes but narrow profit margins, the rate would reflect a higher portion of the property’s return than on a property that is highly profitable. For example, a business that owns an office building with rental income totaling $1 million, but a mortgage of $995,000, would actually be operating at a loss after the $6,000 fee was imposed. In addition, the fee would be particularly burdensome for companies that anticipate incurring losses in their early stages of development.
4. Limited Partnership: A Possible Strategy If Gross Receipts Exceed $250,000
For the vast majority of investors, the CA LLC fee should not deter you from forming an LLC. However, if the impact is severely detrimental, there are several potential solutions that can be explored. A competent attorney or accountant can work with you to avoid this fee. One method may be to form a limited company. The partnership must be established with an LLC as the general partner (assuming liability) and the owners of the property as limited partners. By forming a limited partnership with an LLC acting as general partner, the landlord can likely avoid the higher fee imposed on an LLC while also protecting personal liability. While this may be a possible solution, it is strongly recommended that you consult with an attorney or accountant regarding the best course of action.
While there are risks associated with real estate, with smart decision-making and careful preparation, real estate can be a worthwhile investment. However, the first step is to make sure that you and your property have been adequately protected. We hope this article will help property owners begin to discover the various ways one can own an investment property, as well as the protections and benefits that investment property provides.