In an area where real estate is a highly valuable—and often appreciating—asset, holding residential properties as income-producing rentals is not uncommon.
What should you know if you are thinking of renting out your property from a business planning and estate planning perspective?
Liability Considerations
At the outset, any time that someone else sets foot on “real property” (the legal term for real estate), the landowner enters the realm of potential liability to that person.
If an unsafe condition exists on the property (whether or not known) and someone gets injured, the property owner is likely to be named in any resulting lawsuit.
The first line of defense against such liability is, in our view, adequate insurance. While we are not insurance brokers, we recommend that clients consult with their insurance agents to determine adequate coverage and policy limits based on their specific circumstances. Most clients who own rental property opt to obtain:
- All-risk casualty coverage for the premises, which insures against a loss to the real property itself (e.g, damage to HVAC systems, appliances, etc., caused by the tenant).
- Premises liability coverage, which insures against injuries and property damage to others on the premises.
- An umbrella insurance policy as an extra layer of caution.
Insurance is a good start. However, we also recommend that clients who own either commercial or residential rental property strongly consider transferring the property into an entity with limited liability protection—typically a limited liability company (an “LLC”).
Real property held in the name of an individual means that the individual (and all of his or her assets) may be at risk in the event of loss, injury, or death on the premises.
Real property held in the name of an entity, such as an LLC, on the other hand, can limit potential liability exposure and recovery to only those assets held in the entity. However, there is a catch. The owner who wants the protections of an LLC must commit to the process. The owner must maintain “corporate formalities,” such as maintaining separate books and records, a separate bank account, entering into leases and contracts in the name of the entity, and holding a rental license in the name of the LLC. State law also requires the filing of an annual report to the state authority regulating LLCs. A worst-case scenario could be holding property in an LLC, believing that you have the protections of the LLC, but finding out after an injury occurs on the premises that, because you weren’t observing corporate formalities, your personal assets are now at risk. Courts are generally reluctant to “pierce the veil” and disregard the liability protections of an LLC except in egregious cases. However, having adequate insurance in place is doubly important where the shield of limited liability protection of an entity is in doubt.
Transfer and Recordation Taxes
An individual owner wishing to transfer real property from their own name into an entity or trust for estate or business planning purposes typically needs to convey title to the property via a deed and then record the deed with the applicable governmental agency that maintains land records for that jurisdiction.
This can result in the assessment of both a tax on the transfer of ownership of the property (a “transfer tax”) and a tax on the recordation of the deed and/or other instruments (a “recordation tax”) with the applicable governmental agency.
A common exception to the transfer and/or recordation taxes (called an “exemption”) is provided where the real property is being transferred from an individual to a revocable trust for estate planning purposes. Exemptions for transfers to other types of trusts and estate planning vehicles vary by jurisdiction.
When transfers are made from an individual to a business entity such as an LLC, the hunt for an exemption can become much more complicated. Moreover, if the asset is ever transferred out of the LLC, there is unlikely to be an exemption.
In addition to a business attorney or estate planning attorney, the client should consult with a real estate attorney to determine if a proposed strategy would be exempt. Why? In a non-exempt transaction, clients could end up paying between 1% and 4% of the value of the property in transfer and recordation taxes simply for transferring the property from their individual names to an LLC wholly owned by them. In many cases, clients find that this would be cost-prohibitive and a major factor in determining how to hold title to the rental property.
Rental Housing Laws and Regulations
An additional consideration when determining whether to hold real property individually or in a trust or business entity is the extent to which the type of ownership results in differing treatment under the jurisdiction’s rental housing laws.
Many jurisdictions require licensure of rental properties. The consequences of failing to obtain a valid license can be draconian, including severe limitations on the right to sue a problem tenant for unpaid rent. It is critical that your rental license match the name on the deed.
Additionally, certain jurisdictions have rent control laws that limit a landlord’s ability to raise rent. However, these exemptions can be lost when transferring ownership of an entity to a trust or an LLC—particularly and most notably in the District of Columbia. Again, consultation with a real estate attorney, in addition to your estate planning or business attorney, will be critical to understanding all of the consequences of ownership and transfer.
Concluding Thoughts
While investing in income-producing residential real estate can be an impactful way to build wealth while owning an appreciating asset, it is complicated! Unlike what the Internet might tell you, it is not as simple as going online, forming an LLC on LegalZoom, and having the new LLC appear on the deed to the property. There are immediate and long-term planning considerations.
How can we help you if residential real estate is—or may become—part of your investment portfolio? Contact Tim Canney, chair of the business and tax practice at Bulman Dunie, or Jeremy Rachlin, chair of the estate planning practice at Bulman Dunie.
