Alabama: How to Hold Title to Real Estate

This is an excerpt from my book, Alabama Landlord's Desk Reference and Forms Book, 3d edition, 2015:

There are six basic ways to hold title to your rental property in Alabama:

1. (1) Your own personal name. The pros and cons are:
   • It is the easiest
   • If you later sell and hold the financing, you can do three to five such transactions a year without the involvement of a Licensed Mortgage Loan Originator, depending on who you believe. The issue is related to something called the SAFE Act, in case you want to research this further. We are currently in a transition stage on this issue. Seller financing issues are beyond the scope of this article. If you are interested, I have blogged extensively about this on my Investing in Real Estate blog, at www.deniselevans.wordpress.com .Click on the category for “seller financing” to see all the posts and comments.
     
   • You can file eviction and other lawsuits without hiring a lawyer, if you are comfortable doing that. Corporations and LLCs cannot represent themselves, except in small claims court. Eviction must be filed in District Court, not small claims court. At the time I am updating this book (March of 2015) there is a bill pending on the Alabama Legislature to allow members or shareholders of small LLCs or corporations to file their own lawsuits. If you want to check on the progress of that proposed law, it is HB4.
     
   • Cons: No asset protection, limited estate planning tools, limited tax-savings options upon a later sale.If you later decide to transfer the property into a corporation, LLC or trust, that could be a taxable event that will cause you to owe income taxes, even though no money changed hands.
     
     
2. (2) You can own the property with other people, but as individuals. The pros and cons are the same as individual ownership except in the case of tenants in common with right of survivorship, which is often used as an asset protection tool.
   • Tenants in common. Each owner has an undivided share, and can sell their share or leave it to anyone they want in their will. If one dies without a will, it goes to his intestate heirs. A creditor of only one owner can execute on that owner’s share and force a sale of the entire property on the courthouse steps. That creditor receives the former owner’s share of the sale money, and the rest of the money goes to the other owners.
   • Joint tenants with right of survivorship. Each owner has an undivided share. If someone dies, his share goes away, until there is only one survivor.If an owner sells or mortgages his share, or a creditor executes against it, then the entire arrangement automatically deteriorates into a tenancy in common, with the same consequences as above.
   • Tenants in common with right of survivorship. Each owner has a life estate, and the possibility of owning everything if he outlives the other owners. This seems the same as joint tenants with right of survivorship, but the legal theory behind it is different.If an owner sells or mortgages his interest, or a creditor executes on it, the new owner has only a life estate, measured by the life of the first owner. In other words, if ABC Bank executes on Joe Smith’s life estate, ABC Bank owns nothing the minute Joe dies.The property cannot be sold on the courthouse steps and money divided.The property is safe from all creditors, except a creditor who has a judgment or lien against ALL the owners.
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4. (3) Limited Liability Company (LLC). The pros and cons are:
   • Conduit tax treatment. In other words, the entity is treated like a partnership for income tax purposes, with all income and losses flowing through to your personal name, rather than having the regular corporate double taxation—once on corporate income, and secondly on distributions to owners.
     
   • One person can be designated the “managing member” and always remain in control of the LLC, even if they own a minority interest. This is different from a corporation, in which the other shareholders can always vote someone out of power.
     
   • Asset protection. In most states, if you have more than one member in the LLC, and a creditor takes a judgment against only one of you, that creditor cannot reach inside the LLC and sell the property to satisfy the judgment. The creditor can get what is called a “charging order,” which is kind of like a garnishment. The charging order will be from the court, and it will say something along the lines of, “Hello LLC. This is the Judge speaking.If at some point in the future you decide to distribute money or property to your members, you can’t send any to the member who has a judgment against him. Instead, you have to send that money or property to the judgment creditor.” The LLC can decide to just keep stockpiling money until the debtor works something out with his creditor. The LLC isn’t required to make distributions, it’s just told that, if it does, the money goes to the creditor.
     
   • Estate planning that takes advantage of the annual gift exclusion. In 2015, you can give up to $14,000 worth of gifts to each of your children, grandchildren, etc., without paying any income taxes.You can do this each year, up to that year’s exclusion amount.Because of some funny math that is beyond the scope of this article, you can give away an LLC interest worth only $14,000, even though the equity in the underlying property might be dramatically more than $14,000.If you want to know more about this, Google {limited liability company valuation gift tax exclusion.}
     
   • In Alabama, as in many other states, LLCs pay an annual franchise tax, based on the value of the equity in the company’s assets.Family LLCs pay a much smaller amount. Check with your lawyer or accountant about this issue, because you might want to designate your LLC as a “Family LLC.”
     
   • Drawbacks:If you want to raise capital from investors, a corporation is better because the LLC usually has strict limitations on transfer of ownership interests.Also, an LLC is created for a limited time period, whereas corporations are usually perpetual. If you anticipate eventually selling your portfolio and deferring taxes through some sort of stock swap, you’ll need a corporation.Basically, if you want to eventually be “big,” then start out early thinking big, and form a corporation. Otherwise, if you later transfer assets from your LLC to your corporation, that will be a taxable event and you’ll owe huge income taxes at that point.
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9. (4) Corporation. The pros and cons are pretty much the same as discussed in the LLC section, with some minor exceptions.A corporation requires more documents to create, and adherence to formal rules regarding meetings, notices, etc.An LLC can be set up so one member will always make all management decisions, even if they own a minority interest in the LLC. With a corporation, once your ownership drops to less than 50%, other people can vote against you and change everything.Corporations can make a Subchapter S election by filing form 2553 with the IRS. This allows them to be taxed like a partnership, but still enjoy the advantages of the corporate structure. There are size limitations, but when you outgrow the Subchapter S requirements, you can simply change your tax status without transferring assets. In other words, no taxable event, and no income taxes due.
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11. (5) Self Directed IRA. The pros and cons are:
    • One big benefit is the ability to defer income taxes until you start making distributions, at retirement age. At that time, you will probably be in a lower tax bracket.
      
    • You must pay someone a fee to manage your IRA paperwork. The fee is generally based on the size of your portfolio—the more valuable the equity in your holdings, the higher the fee.You might feel like the IRA manager does not do much to justify their fee, but that is the price tag of safety from IRS audit.
      
    • The investment cannot be dependent on your personal efforts: You must pay someone else to manage the property. If you self-manage rental property that is in your self-directed IRA, you could lose all your tax benefits upon an audit, and owe a ton of money in back taxes, penalties, and interest.One way around this is to put the real estate into an LLC, and then have your self-directed IRA invest in the LLC, not the real estate.
      
    • The investment cannot be dependent on your personal credit or cash: You cannot infuse more money into the IRA in order to pay obligations. All bills must be paid by the IRA itself. If rents decline and the IRA still has mortgage payments and such, it might be forced into default and foreclosure. This is another reason why the LLC/IRA combination makes more sense.For the same reason, if you must borrow money in order to finance your purchases, or refinance to buy more things, you can’t guarantee the debt, or you will run afoul of IRS regulations. You can find lenders who will loan money purely on the real estate, with no guarantee, but you must have more equity in the property.
    • This vehicle is safe from most creditors, except possibly some bankruptcy trustee super-powers.
      
    • If you have a regular self-directed IRA (in which contributions are made with before-tax dollars) then when property is sold at a profit within the IRA, and later distributed when you retire, the entire amount will be taxed at ordinary income rates.If you set up a Roth-IRA, and fund it with after-tax dollars, then later distributions will be tax free.
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13. (6) Trust. The pros and cons are:
    • Asset protection, assuming you do not run afoul of the rules.If you want more information on this topic, here is a good Wikipedia article for a starting point: http://en.wikipedia.org/wiki/Asset-protection_trust
      
    • More flexibility than an IRA, particularly in the ability to use money before your retirement age.
      
    • The trust will require an attorney to set up, it will have to file its own tax return each year, and income is taxable to the trust.

[1] A “conduit” is a channel through which something is transported. Think “water pipes” or “electrical conduit.”In the investing world, it means benefits (usually tax benefits) are transported through the entity to the investors, without any change in character or amount.

[2] Form 2553 can be found here: http://www.irs.gov/pub/irs-pdf/f2553.pdf