Create LLC for family-owned rental?

[Steven Straughn]

Hi BiggerPockets. I'm looking for some advice regarding the transfer of property from my in-laws to their 3 adult daughters. I will, of course, seek advice from a legal/tax professional, but recall from time that I previously spent on this site that there are a lot of knowledgeable people who are willing to help. 

The background: The house (located in Napa, CA) is owned outright by my wife's parents. They have poor credit, slightly below average income, little savings, and are nearing retirement (1-2 years). My father-in-law will have a decent pension. They will be moving to San Diego after retiring (possibly living with us) and will be renting their house out. Long-term, the plan is to hold onto the house and pass it on to their 3 daughters. They have mentioned setting up a trust to facilitate that, but have also said that they are open to other arrangements that would make better use of the property. 

I wonder if it wouldn't be more beneficial to the family to create a multi-member LLC to hold the property. Rental income would flow through the LLC to my in-laws the same as if they retained personal ownership, but I think an LLC would allow flexibility in how the property is used for tax purposes. It seems to me that the 3 daughters would be able to realize some tax benefits through the LLC, whereas my in-laws would not be able to take full advantage on their own. Also, putting the home in a trust would prevent the daughters from potentially using the equity (not likely, but who knows?).

I'm sure there are many factors of which I am ignorant, and look forward to you setting me straight. Thanks for reading. 

[Katie L.]

@Steven Straughn

You've raised a number of issues in your one short post.  I don't know all the facts so I will refrain from giving any advice but will mention a couple of things.  Do not take any of the following as legal advice and consult an attorney or other professional.

In California, an LLC will be subject to an $800 minimum tax, just for existing. The income from it will pass through and be picked up on the owners' individual income tax returns. It will be taxed at ordinary rates unless any of the owners qualify for the brand new 20% pass through rates which are rather complex. So the benefits to the LLC I could see are liability protection of course, multiple owners, and possible income tax advantages depending on the rate arbitrage of the owners.

You could put it in a trust but then the question becomes what kind of trust to create. The most common is probably your standard grantor/family/living trust. If your in-laws don't have an estate plan, they will likely want to create an estate plan if only for the sole reason of avoiding probate, which in CA can be a very expensive and long hassle, even if all parties get along amicably. Maybe their estate is under the threshold requiring probate, but if they continue to hold the property not in an LLC or other entity, they will likely want to create a family trust. Again, I don't know their circumstances so I will not give advice but suffice to say this is probably something you will want to look into. In the very least they should have wills (and probably health care directives, HIPAA documents, powers of attorney, etc.).

You can also create a trust that is a separate taxpaying entity such as a QPRT or gift trust. This might make good sense if the 3 kids plan to continue to operate the property as a rental after the in-laws die because a trust can have multiple owners and the trust document can govern various ownership percentages and rules for management and partitioning the property, etc. One of the downsides is that trusts hit the highest tax brackets rather quickly so if this property is producing profits, could be subject to tax at higher rates faster than if you created an LLC. The family trust if it is a grantor trust will be subject to tax on an individual income tax return at normal rates, not the accelerated trust rates. The higher trust tax rates are for separate tax-paying trusts which are usually irrevocable trusts.

You'll want to be cognizant in all of these options of the gift tax consequences of how the parents transfer ownership and when they do so.  Sounds like the in-laws aren't entirely wealthy that they may not owe actual gift tax but they could create a filing obligation.  You can also consider a sale to the daughters.

There are two other major considerations that I don't know if you've thought about though and those are capital gains taxes and property taxes. Without getting into too much detail, the rule is sort of like this: when you sell property, you take the money you sell it for and subtract your basis to get a net gain (or loss). Your basis though, has a major difference between whether you are gifted the property or whether you inherit the property. You didn't give details about when the parents bought the house or how much its worth, but if they bought the property a long time ago for a low price, then they have a low basis. If they gift the property, the recipient takes a "carry over" basis meaning they also get the parents' basis. If, however, the kids inherit the property, they take a "stepped up" basis or "step up in basis" and their basis becomes the fair market value on the date of death. So.... say, parents bought the property 15 years ago for $200k. It's worth $400k now. They die 5 years from now and it's worth $600k. You sell the property another 5 years after that for $800k. If they GIFT the property, you get their basis of $200k, so you will pay capital gains on $600k (800-200). If you INHERIT the property, you get a basis as of the fair market value as of the date of their death and you pay capital gains on $200k (800-600). Could potentially be a huge difference there that you want to consider. If you do not plan to keep the property in your family after the in laws die, could possibly be no gain if you sell it for its fair market value (worth 600k when they die, take a stepped up basis of 600k, sell it soon after death for FMV of 600k, equals no gain).

The other major consideration sort of relates to the basis issue is with property taxes. If the parents bought the property a long time ago for a low dollar amount, it likely is assessed at a relatively low value in comparison to its actual fair market value. Once the property goes through a change of ownership such as placing it into an LLC if the owners are different or inheriting it or gifting it, the property could potentially be reassessed to current fair market value, and property taxes will be based on that new, probably higher, value of the property. Can maybe use a parent-child exclusion but I believe this option would be lost if the property is in an LLC. A parent-child exclusion stops the property from being reassessed if the transfer is from a parent to child but I think this cannot be done if the property is in an LLC since at death the child would receive an LLC interest and not the property itself, since the LLC is the owner of the property. So.... if they bought the house only a few years ago, then maybe not a big deal, but if they bought it a long time ago and it has a low assessed value, this could mean major dollars in terms of property taxes every year, which is often overlooked.

Hope that's some food for thought.  I'm sure I've missed several things but you raised a ton of issues in your one short post.  

Again, I do NOT have all the facts here so none of the above is intended to be legal or professional advice.  This post and information does not create an attorney-client or CPA-client relationship.