I plan on converting my primary home to a rental in Ohio. I owe no mortgage, and the property belongs to me. I will be purchasing both rental liability insurance and umbrella insurance. My attorney suggests getting the property into an LLC, but recommended I check with a CPA for tax implications. What type of LLC is most tax advantageous? Can I depreciate an asset with an LLC? What are the pros and cons?
This is a complex topic.
A limited liability company (LLC) is a form of business that provides limited liability protection to the business owners without the requirements of forming and maintaining a corporation. Some business owners choose to limit their personal liability with liability insurance, making an LLC unnecessary.
Many tax experts strongly advise against owning real estate in a separate entity (LLC or corporation) because of the tax advantages of owning it personally, and the additional tax that can result when money is withdrawn from the entity.
Since you intend to rent the property, it will generate taxable income. Naturally, you will want to minimize the tax burden. When an individual owns a rental property, he or she reports the income on a Schedule E. In Pennsylvania, Schedule E rental income is subject to federal and state income tax, but not self-employment and local income tax. Keeping the rental income as Schedule E income rather than business income can result in a savings of about 16 percent.
Not always, but under certain circumstances, transferring the property to an LLC, which would be an operating business, could turn the passive rental income into business income subject to self-employment and local income tax. If you use an LLC to own the property, you should structure the operation so the passive nature of the income is maintained.
Taxation of an LLC is dependent on the number of owners (called members) and whether the LLC has elected to be taxed as a C corporation or an S corporation.
The default taxation of a single-member LLC is as a disregarded entity, where the income is passed through to the owner, who completes a Schedule C for the business. True business Schedule C income is subject to self-employment tax of about 15 percent, in addition to federal, state, and local income tax.
The default taxation of a multiple member LLC is a partnership. A partner’s share of partnership business income is subject to self-employment tax in addition to federal, state, and local income tax.
As stated earlier, you should structure the operation so the passive nature of the income is maintained.
An LLC can elect to be taxed as a C corporation or an S corporation. In this situation, this election is not necessary, and would increase the likelihood of unnecessary additional tax.
Tax advantage on sale of a personal residence
The sale of a personal residence can result in a huge tax savings if certain requirements are met. For federal income taxes, a single taxpayer can exclude up to $250,000 in gain on the sale, and a married taxpayer can exclude up to $500,000 in gain. The taxpayer must have owned the home and lived in it as his or her principal residence for two of the previous five years before the sale. Pennsylvania also offers similar gain exclusion. Transferring ownership to an LLC will eliminate this potential tax benefit. If you sell the property in the next five years, then transferring ownership to an LLC could cost you many thousands of dollars in unnecessary taxes.
Costs of the transfer of ownership
In addition to the attorney’s fees, transferring ownership to a separate legal entity could trigger state or local transfer taxes. In Pennsylvania, these transfer taxes amount to 2 percent of property value, which means thousands of dollars in taxes on the transfer. You should understand whether the transfer to an LLC would result in real estate transfer taxes.
All ordinary and necessary costs of operating the rental operation, such as insurance, property taxes, and repairs and maintenance, are deductible against the income. The owner can depreciate his or her cost of the residential real estate over 27.5 years. The depreciation reduces the owner’s basis, and the depreciation might have to be recaptured as taxable income when the property is sold.
A transfer of the property to an LLC could trigger immediate costs and taxes. The advantage of the limited liability with an LLC could be obtained with proper insurance. The potential exclusion of taxation of the gain on sale of a personal residence would be lost immediately.
I don’t know the advantages of the LLC the attorney is contemplating when he recommended it. Given the information available, I would recommend against an LLC.
This advice is based on the limited facts available. You should engage a qualified CPA for a more thorough analysis.
For more resources, check out PICPA’s Money & Life Tips, Ask a CPA, or CPA Locator.
Answered by: Harold P. Eck, CPA, is an individual practitioner in Jersey Shore, Pa.