Purchasing real estate requires careful consideration of price, location, and return on investment. Equally important is the investment vehicle a buyer chooses when making a real estate purchase.
Limited Liability Companies (LLCs) are an important, and often preferred, investment vehicle that buyers should consider when acquiring real estate because of tax and liability benefits, along with the flexibility offered in forming and operating the LLC.
LLCs have the advantage of being taxed as “pass-through” entities. This means that income generated by the LLC is passed through to the members and taxed at the member’s personal tax rate. If real estate was instead held by a corporation, any income generated could incur double taxation – first at the corporation level and then again at the individual level.
The IRS treats a Single Member LLC (SMLLC) as a sole proprietorship – in essence, the LLC does not file a tax return and the money generated by the LLC is included on the member’s personal tax return. As an alternative, an SMLLC can choose to be treated as a corporation for federal tax purposes.
LLCs with more than one member can choose to be taxed as a partnership or a corporation. In the case of a partnership, profits are distributed to members, usually based on their respective ownership in the entity, and each member pays taxes based on the share of income received from the LLC.
LLCs provide individuals with advantageous liability protections. Generally, members of an LLC are not personally liable for the actions of the LLC, whereas partners in a partnership would normally incur personal liability. Importantly, this means that in the event of a judgment only the assets owned by the LLC would be collectable, as opposed to any assets owned by the individual(s).
Some buyers prefer owning real estate personally and attempt to mitigate risk with insurance and/or an umbrella policy. While this strategy may protect the buyer in certain scenarios, insurance policies do not cover all situations, which leaves the buyer/owner open to unwanted risks. For instance, insurance does not typically cover all tenant issues, encroachment/property boundary issues, breaches of contract with vendors, and many torts.
For example, let’s say a landlord personally owns a rental property with $200,000 in liability insurance and a $1 million umbrella policy. If the tenant sues the landlord for a slip and fall injury and is awarded damages of $2 million the insurance policies will only cover up to $1.2 million. This leaves the landlord’s personal assets vulnerable to collection for the remaining $800,000. Had the landlord owned the real estate through an LLC the tenant could only have gone after the LLC’s assets, thereby keeping the landlord’s personal assets out of reach.
Consider a slightly different scenario where the insurance policy does not provide coverage for an issue such as in a property boundary dispute where damages to the neighboring property are $1.2 million. In this case, the landlord would be personally liable for the full $1.2 million and all his assets would be subject to collection, in addition to the possible legal fees. Similarly here, by purchasing real estate through an LLC the buyer could have mitigated risk and prevented his personal assets from being exposed to collection.
A hallmark of the LLC is the flexibility it provides to members. Unlike a partnership, an LLC need only be comprised of one member. Members of an LLC can actively manage the entity without jeopardizing the limited liability benefits. Alternatively, an LLC can be set up as “manager-managed,” where members delegate management and operation duties to a non-member. In the case of real estate, a new LLC can be created for each separate property, which has the benefit of protecting other LLC-owned properties from cross-liability in the event of litigation.
Importantly, the members of an LLC may define the roles of each respective member by contract, including the economics of the relationship and any fiduciary duties owed. This stands in contrast to corporations, where shareholders are restricted from altering certain provisions that are required under state law.
Setting Up an LLC in Pennsylvania
Forming an LLC in Pennsylvania requires complying with several government regulations, including completing and filing a certificate of organization.
While an operating agreement is not required when forming an LLC in Pennsylvania, it is good business practice to have one in place, particularly where the LLC is made up of more than one member. Title companies also require an operating agreement when buying, selling or borrowing against real estate. An operating agreement serves as the governing document of an LLC. It details the rights and obligations of members and outlines how the LLC will operate.
Buying Real Estate as an LLC
When buying real estate, the best option is to make the purchase through an already formed-LLC. However, since sales can occur quickly and forming an LLC costs time and money, buyers do not always have an LLC on hand when signing an agreement of sale.
While it might seem appropriate to close the sale and later assign or transfer the property to an LLC once it has been formed, this transaction will result in a Pennsylvania (1%) and Philadelphia (3.278%) realty transfer tax. This tax will come on top of the transfer tax already paid on the initial transaction.
It is important to note that buyers who own real estate in their own name are not exempt from transfer taxes just because they are the only member of the LLC. Under the current law, transferring property owned in the buyer’s name to an LLC wholly-owned by the buyer will still result in a transfer tax.
In order to avoid this second transfer tax while maintaining the flexibility to open an LLC only when required, it is necessary to include a provision in the agreement of sale related to assigning the contract. This provision should expressly state that the buyer is acting on behalf of a yet-to-be-formed entity (in this case, an LLC) with the intent to assign the sale to the future entity (the Assignee). In addition to these steps, Pennsylvania law also requires compliance with other regulations when structuring the transaction in this manner.
Once the buyer is prepared to close the transaction the sale can be assigned to the newly-formed LLC. This scenario provides a buyer with the flexibility to quickly enter into a real estate contract while maintaining the LLC’s ability to purchase the property and avoid a second transfer tax.
Real estate purchases already involve wading through complex rules and regulations even before considering the proper investment vehicle. LLCs are an important tool that buyers should keep in mind when planning a transaction. Our office can work with you to determine how to best structure your real estate transaction. Contact us to learn more at 215-717-2200.
Disclaimer: Nothing in this article should be considered tax advice. This article is solely for informational purposes. Please consult a qualified CPA or accountant for tax advice and guidance.