I am frequently asked if a limited liability company (LLC) should be used to purchase a second residence. It is often an excellent choice for clients. There are many benefits of owning a residence in the name of an LLC.
The top advantage is protection from personal liability arising from the property. Certainly a property owner can purchase general liability and umbrella insurance coverage, but the small up-front cost of forming an LLC (typically less than $750) to achieve permanent and unlimited protection is difficult to match. (There is also an annual LLC registration requirement with a small fee that is typically around $200 per year.) The limited liability protection is especially important for vacation homes that may be rented or used by others while your client is not present.
Another advantage is privacy. In most states, including Pennsylvania, Delaware, and New York, the owners of an LLC are not of public record. This is one reason, as reported by The New York Times, that most New York City luxury condominium units are owned by an LLC and not in the name of individual owners. In other states, such as New Jersey, confidentiality of owners can be maintained if a manager is reported.
The ease of transferring ownership is another benefit. Once the deed is listed in the name of the LLC, the deed does not need to change until the property is sold to a third party. Property ownership can be transferred confidentially by the assignment of LLC membership interests from a parent to trusts, estates, children, etc., without changing the deed in the name of the LLC and without dealing with all of the associated filings and fees.
Understand that ownership of an LLC membership interest is an intangible asset for probate purposes upon death. If a client owns a second residence, or multiple residences, in a state in which he or she is not a resident, they need not incur ancillary probate proceedings in the other state.
An LLC interest is also an intangible asset for state inheritance tax purposes – the real estate will be taxed by the state in which your client resides at the time of death, as opposed to the state in which the real estate is located. You will need to compare the inheritance tax of your client’s resident state to the state in which the property is situated to determine if there is a significant difference in tax cost. For example, a New Jersey resident can avoid a potential Pennsylvania inheritance tax on his or her Pennsylvania property by using an LLC. On the other hand, in the case of New Jersey property owned by a Pennsylvania resident without a surviving spouse to inherit the property, Pennsylvania has a 4.5% inheritance tax on the LLC interest passing to your client’s children, while New Jersey does not tax real estate passing to children. However, there is no Pennsylvania inheritance tax when the LLC interest passes to a surviving spouse. It is common estate planning for a Pennsylvania resident to later become a resident of a state without a state inheritance tax (such as Florida), so that on the death of the surviving spouse there is no inheritance tax.
Most LLCs that own a personal residence do not require any type of federal or state income tax return. Basically, when there is no rental activity, a client simply deducts the associated real estate taxes on his or her individual tax return as if the client owned the property directly. If your client rents out the vacation home, your client will file an income tax return whether the property is in an LLC or not; so, considering limited liability is paramount for a rental, an LLC should be considered.
Unlike annual record maintenance requirements for corporations, an LLC has no required formalities after formation and the signing of a simple operating agreement, other than an annual state registration.
The formation of an LLC is not without issues that may concern some clients to a degree. The most common is that when your client is obtaining a mortgage loan, some lenders may charge a higher mortgage rate to an LLC. A second, potentially more material, concern is the possibility of additional state inheritance tax costs for LLC ownership (adjusted for the amount of additional state ancillary probate costs of not using an LLC) as described above. Also, in Pennsylvania, if your client purchases real estate in the client’s individual name and later decides LLC ownership is preferred, Pennsylvania will assess a realty transfer tax, even if your client is the sole owner of the LLC. Therefore, it is recommended that LLC ownership be considered at the time of the purchase and is not deferred until after closing.
In general, an LLC holds numerous benefits for clients who own other personal residences. Sometimes titling property in the client’s individual name may be preferred, however, when there is a concern for additional inheritance taxes or, less so, a concern for the slightly higher mortgage rate or modest cost of formation and annual registration.
Your client will have to decide if those factors outweigh the benefits of using an LLC.
Herbert R. Fineburg, LLM (Taxation), is shareholder and managing partner in the Philadelphia office of Offit Kurman PC. He can be reached at firstname.lastname@example.org.