Should I put my rental (plan to sell) in an LLC to avoid C-gains?

18 Replies

Here's the scenario...

My wife and I lived in this house for 4 years, rented it out the last 4 and are thinking about selling it. I'm wondering if there are any advantages to putting in an LLC right before I sell it in order to avoid paying more on my taxes this year? I know I'll have to pay capital gains regardless but wanted to see if there was something I'm missing here. Thanks in advance for your feedback.

Hello Caleb,

The default tax entity classification for a single-member LLC (SMLLC) is a "disregarded entity". For federal income tax reporting this means the SMLLC is dissolved and there's no distinction between the SMLLC's assets/income and the owner's assets/income.

The tax treatment of you holding the property directly vs through a SMLLC taxed as a disregarded entity will be 100% the same. However you'd be out the LLC filing fees in the latter situation, so the LLC would appear to be disadvantageous if viewed solely through the lens of income tax compliance.

If you're looking to avoid tax I'd suggest you read up on a "like-kind exchange" aka a "1031 exchange". Your CPA/EA will be able to elaborate.

-Eamonn

@Caleb Dryden , No matter the entity, the gain will be recognized as of the date of the sale. If you own it you pay the tax. If a disregarded LLC owns it as @Eamonn McElroy said  you pay the tax.  If a regarded entity owns it then the entity pays the tax and gives you a partnership or corporate return with the tax being paid.  The tax will be paid.

However, Eamonn also mentioned the way for you to avoid paying that tax indefinitely including recapture of the 4 years of depreciation. If you are planning to purchase more investment real estate then a 1031 tax deferred exchange is the process to use. You sell investment real estate and then buy investment real estate paying attention to some rules in the middle and you do not have to pay the tax as long as you own the next property or as long as when you later sell the next property you again do a 1031.

@Caleb Dryden

You missed the window of being able to sell the home and avoid some or all of the gain via section 121 exclusion if you live in the home for 2 out of the last 5 years. However, it appears you not lived it in for 1 out of the last 5 years.

You can decide to live in the house for the next 2 years and use the same strategy.
You can also use the like-kind exchange that was discussed.

Creating an LLC will not help in your case - if anything it will just add up some administration costs.
SIngle member LLC or a multi-member LLC are "pass-through" so the character and types of gain will "pass-through" from the LLC to you and your wife.

@Eamonn McElroy @Basit Siddiqi @Dave Foster thank you for the advice and recommendations. They were very clear and understandable. A couple follow up questions. 

1) What qualifies an LLC as "disregarded?" Or should I say, how do you avoid this classification, since there seems to be no point in having an LLC once it is deemed disregarded.

2) I also have a few rental properties. Is an LLC a better idea in this scenario where I have long-term renters and am holding onto the property year after year? It was my understanding that I can count the rental income as "LLC income" if you will, and file separate from my W2 job, thus avoiding moving up to the next tax bracket. Example: Say I make $70k in my W2 job but making $25k in rental property income. By having an LLC doesn't the IRS view these income streams separately so I'm now getting taxed on the $25k on it's own then the $70k on it's own rather than $95k altogether?

3) What is a situation where an LLC would be beneficial? You guys rock, thanks for your help.

@Caleb Dryden A disregarded entity is one that does not file it's own tax return. Rather all activities for the property owned by the entity are reported on the sole member's personal Schedule E of the tax return. An LLC that is a single member LLC and elects to be taxed as a sole proprietor does not file it's own tax return. It is disregarded and the taxpayer is viewed by the IRS to be the sole member.

@Steve B. I haven't attended any so far. One of my closest friends owns his own successful business. He recommended getting into an LLC and lumping all my properties together. The way he put it was...

There are two advantages to having your properties in an LLC:

-if you get caught in a lawsuit situation, they can only come after your assets (whatever is under the LLC)

-income from your properties (rentals or flips) in the LLC will be taxed separately from your W2 job

But what I'm hearing from y'all, there are no tax benefits to having an LLC? I will always pay taxes on the entirety of the income from properties in my LLC and my W2 job? Unless I 1031 the property I sell of course but this wouldn't apply to a long-term rental.

Again, thank you for the feedback...

@Caleb Dryden

What qualifies an LLC as "disregarded?"

Treas Reg §301.7701-3(b)(1)(ii)

how do you avoid this classification

By electing to have the SMLLC taxed as an S Corporation or C Corporation.

there seems to be no point in having an LLC once it is deemed disregarded

A tax CPA might nod their head in agreement.  A tax CPA familiar with CA tax law might vigorously nod their head in agreement.  (sorry west coasters)  An attorney might disagree.

It was my understanding that I can count the rental income as "LLC income" if you will, and file separate from my W2 job, thus avoiding moving up to the next tax bracket.

You're a bit lost... This is incorrect tax advice from your friend. He is not understanding the tax mechanics of having an LLC. The only way to achieve this outcome would be to elect C Corp tax status, but now you have the problem of rental real estate inside of a corporation and expose yourself to double taxation. Still, holding rental real estate inside of a C Corp does make sense in very limited fact patterns.

You might benefit tremendously from adding a tax CPA/EA and an attorney to your list of external partners.  There are plenty of us on BP who would be happy to have more clients.

Originally posted by @Caleb Dryden :
 I will always pay taxes on the entirety of the income from properties in my LLC and my W2 job? Unless I 1031 the property I sell of course but this wouldn't apply to a long-term rental. 

1031 exchanges do not exclude rental income from taxes. 1031 exchanges defer the capital gains and depreciation recapture taxes  generated from the sale of the property. 1031 exchanges absolutely apply to a long-term rentals. 

Best of Luck with Your Real Estate Investing!

@Basit Siddiqi that makes sense. If I bought a house and it is a JV. Is that a scenario where I would want to do an LLC in both our names before flipping it? Or are the advantages again still only related to liability and not tax breaks on the earnings?

@Caleb Dryden

Great input from members above. 

You asked a question about the selling the rental via a LLC and you got your answer. No actual tax saving.

If you want to flip another property, and you are planning to do it often, getting an S-corp would save self-employment taxes (15.3%) on a part your profit after paying yourself a salary. That is the general statement and a lot goes into determining how much and if it actually makes sense. From a tax perspective ( not legal), the S-corp for flipping activities is not as wasteful as the LLC for rental. S-corp will actually save you taxes.

Like people have mentioned above, it will pay off to have a professional in your team. Good luck. 

Originally posted by @Caleb Dryden :

@Steve B. I haven't attended any so far. One of my closest friends owns his own successful business. He recommended...

And this phrase is the root of the problem. Unless your friend is an accountant, you should ignore his advice on taxes.

While well-intentioned, he took something that possibly does help HIS business into yours - where it does NOT apply. As my colleagues explained, the short story is:

  1. there are no tax benefits from LLCs for rental properties
  2. you may still want to create an LLC (or several) for legal protection reasons, not for taxes
  3. asset protection is for attorneys only, not for friends and not even for accountants
  4. if your business becomes something other than rentals - then you might need an LLC for tax purposes, but it's a separate conversation

Good luck!

@Michael Blank the distinction you made between my friend and I was exactly what I was looking for (but didn't know). He has tax advantages through his LLC (which is not related to rental properties). I didn't realize there was only liability coverage for rental properties within an LLC. Thank you for your response and clearing this dilemma up for me.

@Paul Allen and @Ashish Acharya thanks for your response. I didn't realize LLCs and their benefits differ from one business to the next. My friend has tax advantages b/c he has his own business (outside real estate). I was comparing apples to apples but apparently an LLC through another business avenue is treated differently than RE. I plan to put each property I own in an LLC for liability purposes only. Thanks for your advice and feedback.