Real Estate Asset Protection
Did you know that you can create legal entities that you can use to protect you real estate assets? This article is a summary of the common ways of vesting title in legal entities that real estate investors use for asset protection.
Three legal entities that you can create are C-corporation, S-Corporation, and Limited Liability Company (LLC). Both C-corporation and S-corporation are formed by filing legal documents with the Secretary of State of California. Both of these corporations are distinct entities from the owners and thus shield the owner-shareholder(s) from personal liabilities stemming from the corporations. The difference is that the S-corporation is able to be taxed directly to the shareholders and avoids the double taxation that a C-corporation brings.
Most people who form a corporation will start off with an S-corporation. An LLC is also formed by filing with the State of California. The owners of a corporation are called shareholders but the owners of an LLC are called members. The LLC also provides personal liabilities protection stemming from the LLC (if formed correctly). An important point to remember if you have an LLC is to elect to be taxed as an S-corporation to escape the self-employment tax that is imposed on an LLC.
The final item, a living trust, does not require any legal filing with the State of California. Most people have a living trust to avoid probate and to carry out their estate planning wishes. The LLC and corporations can both be owned by the living trust and provide more extensive asset protection. You should consider one of these for you asset protection.
An important question: Is an LLC or S-corporation better for asset protection for real estate investors? Both LLC and S-corporation will shield you from personal liability because they are a separate entity from you personally. These entities act like a “bomb-box”, a bomb-proof box, shielding you from liability explosions (law suits) within an LLC or an S-corporation. If a child drowns in your rental property swimming pool and there is a $5 million dollar judgment, then all you stand to lose is the asset in your LLC or S-corporation because they serve as “bomb-boxes” shielding you personally from the $5 million dollar judgment explosion within your LLC or S-corporation. That type of creditor we call “inside” creditor because the liability emanates from inside the real estate property. However, an equally threatening liability is from “outside” creditors. If you are personally sued and there is a judgment of $5 million dollars against you, then an “outside” creditor will seek to get inside the LLC or S-Corporation, where your real estate asset is held, to satisfy the judgment.
If your real estate assets are held inside an S-corporation, then the creditor who owns the $5 million dollar judgment will seek to get inside the S-corporation by foreclosing on your stock and taking ownership of it. They can do that because your stock in your corporation is considered your personal property. Once they get control of your stock, they then have voting rights as a shareholder, and they will vote to liquidate your real estate assets and vote to distribute the cash from the liquidation to satisfy the $5 million dollar judgment. And, there is ABSOLUTELY NOTHING YOU CAN DO ABOUT IT.
However, if your real estate assets are held in an LLC then the remedy of the $5 million dollar judgment against you is a "charging order". A charging order is a court order that says if any distribution is to come out of the LLC then that distribution will go to the creditor. There is a way you can out maneuver this charging order. The secret is in the distribution provision of the operating agreement in the LLC. IF another member of the LLC chooses and agrees not to distribute any money from the LLC then your assets will be protected because, in this situation, there will be no cash distribution for the creditor to take. Thus, if you own a real estate asset, an LLC is a better form of vesting because nearly every States’ remedy against an LLC’s member is a “charging order”.
Most Famous Tax Loophole for Real Estate Owners
Real estate owners buy real estate hoping to accumulate and build wealth for themselves and their families. However, some real estate owners are not aware of the biggest tax loophole when it comes to passing their real estate wealth on to their families.
The most famous tax loophole for real estate owners is the “stepped-up basis”. When you inherit a house, the current IRS tax code gives you a stepped-up basis in cost. Your stepped-up basis is the market value on the date of your benefactor’s death. This taxpayer-friendly rule allows heirs to sell the house they received and owe nothing to the IRS. Most real estate investors or owners want to make sure their families are financially taken care of if they die. Often times, they might need to decide whether to give certain real estate to various members of the family. This situation is common when one is advanced in age or has a terminal illness and has to decide whether to give the real estate property to their love one while they are still alive or give it away after they die. The tax consequences are tremendous depending on which route he/she chooses to take.
Principal Residence
Let’s looks an example: Mom bought the house 30 years ago for $100,000 and fortunately, the house is now worth $1 million dollars. If mom were to give the house to her daughter while she is alive, then the daughter’s cost basis in the house is $100,000 and if the daughter sold the house for $1 million dollars then the daughter would pay capital gains on $900,000. Let’s assume that the daughter’s combined capital gain tax rates between State and Federal is 20 percent. Then the daughter would need to pay about $180,000 in capital gain taxes. However, if mom decides to hold on to the house and gift the property to her daughter in a will or a living trust upon her death then the magic of the stepped-up basis kicks in. Because the stepped-up basis magically allows the daughter to “step up” her cost basis to $1 million dollars, she would pay ZERO income taxes to the IRS. This is the only time that the IRS will forgive you for any capital tax gain. The stepped-up basis works for both principal residence and rental property.
Rental Property Stepped-Up Basis
If the daughter receives a rental property at Mom’s death valuing at $2 million dollars and mom bought it for only $1 million dollars, what is the daughter’s cost basis? The answer is $2 million dollars. If the daughter sells it for $2 million she would not pay any taxes. Our mom, in this example, is a very savvy real estate investor and like all savvy real estate investors, she is very familiar with the advantages of taking deprecation expense to offset any rental income and other income to pay lower taxes. Let’s say mom had fully depreciated this particular rental property. Mom had thoroughly enjoyed and depreciated $800,000 of this rental property. Meaning mom had taken $800,000 of depreciation expenses on this property. Now the question is: Does our daughter have to recapture and pay the IRS back for the $800,000 of depreciation expense that mom took? Meaning, can our daughter depreciate the entire cost of the building again? The answer is yes, which means we can take the depreciation expenses TWICE! It is all legal due to the stepped-up basis rule. Thus, if you have rental properties, it is important NOT to give them to your children while you are alive.
Conclusion
Understanding the stepped-up basis is important in terms of leaving more of your real estate wealth that you have accumulated during your life time to your heirs.