Rental Property Protection: LLCs and Asset Protection Trusts

If you own rental property, there are many ways to hold title, and different methods offer different levels of asset protection and different tax ramifications. Let’s explore some of these different methods of holding title, as well as some of the advantages and disadvantages of each, the asset protection offered (if any), and the different tax ramifications.

For Individuals: Sole Ownership / Sole Proprietorship

If you’re unmarried, you may own rental real estate in your individual name.

Sole Proprietorship Advantages:

This is the simplest method and the way most individuals typically take ownership of real estate. The title is reflected on the Deed as simply being in your individual name.

Sole Proprietorship Disadvantages:

Your interest must go through probate on your death.

Sole Proprietorship Asset Protection:

This method of taking title offers no asset protection whatsoever.

Sole Proprietorship Tax Ramifications:

You file a Schedule E as an attachment to your IRS Form 1040 to show rental income and loss.

For Two or More Persons: 3 Basic Methods

For two or more persons, there are 3 basic methods of holding title in Virginia, Maryland, and the District of Columbia. Please note that the word “tenant” when used in the context of owning real estate is a synonym for “owner” – this confuses many people because most people think of tenants as person who rent property from a landlord.

• Tenancy in Common: With tenancy in common ownership, two or more persons (related or unrelated) hold title to real estate jointly, with equal or unequal percentages of ownership.

• Joint Tenancy with Right of Survivorship: Joint tenancy exists when two or more people own title to real estate jointly, with equal rights to enjoy the property during their lives. If one of the owners dies, their rights of ownership pass automatically to the surviving owner(s) through the right of survivorship.

• Tenants by the Entirety: This method of holding title can only be used by married couples. Tenants by the entirety (T by E) is ownership in real estate under the legal fiction that the married couple is one person for legal purposes, and that each spouse effectively owns the entire property, not just half of the property.

Tenancy In Common (TIC) Advantages:

• Each owner has the right to occupy and use the entire property, which is great if you’re the owner that wants to occupy and use the entire property.

• Each owner can sell or give away that owner’s percentage ownership at any time, either during life or upon death. This means upon the death of one owner, that owner can pass his or her interest to any other person(s).

Tenancy In Common Disadvantages:

• Each owner has the right to occupy and use the entire property, which often leads to disputes if you’re the owner who does not want to use and occupy the property.

• If you want to rent the property but the other owner decides to live there, you’re out of luck. This often occurs with inherited real estate.

• Each owner can sell or give away that owner’s percentage ownership at any time, either during life or upon death, which means you may find yourself co-owing the property with one or more strangers or distant relatives.

• Tenancy in common doesn’t provide automatic survivor rights. All owners have liability for any debts against the property, such as property taxes. This means that each owner is liable for the full amount due. If one owner is unable to pay their portion, the other owners are liable. Any judgments or other liens against the property must be paid off before the property can be sold.

Tenancy In Common Asset Protection:

• Tenancy in common offers very minimal asset protection.

• A creditor against one owner can place a judgment or other lien only against that owner’s portion of the property. A creditor who has a judgment or other lien against one of the owners can petition the court to divide (partition) the property and force a sale in order to collect on its judgment or lien, but the creditor will only be able to collect from the debtor’s share of the property.

Tenancy In Common Tax Ramifications:

• All owners file a Schedule E as an attachment to IRS Form 1040 to show their share of rental income and loss.

Joint Tenancy with Right of Survivorship (JTROS) Advantages:

• One main advantage to holding title as Joint Tenants with the Right of Survivorship (JTROS) is that ownership is passed to the surviving owner if one passes on, thus avoiding probate when one owner dies.

• Another benefit is that neither party in the ownership needs to be married or even related. If the owners are not married, they can sell the property without a court petition if all parties agree to the division of property.

• The responsibility for the property is shared between owners, meaning that all financial obligations of owning the property belong equally to everyone, not just one individual.

Joint Tenancy Disadvantages:

• Although legally the responsibility for the property is shared between owners, not all owners abide by their financial obligation, often effectively forcing one or more of the other owners to take responsibility for paying the financial obligation or else risk losing the property to foreclosure or tax liens.

• Any refinancing, renting, or other use of the property for financial gain must be approved by all owners.

• The interest of one owner cannot be transferred at death to an external party after one dies, as it automatically goes to the surviving owner.
Joint Tenancy Asset Protection:

• JTROS offers very minimal asset protection.

• Creditors can place judgments or other liens only against the debtor’s portion of the property. However, a creditor who has a judgment or other lien against one of the owners can ask the court to divide (partition) the property and force a sale in order to collect on its judgment or lien, meaning that each of the owners risks potentially losing the property due judgments or other liens against just one owner. Also, a creditor with a judgment or other lien against one owner can wait to see if the other owner(s) die first, leaving the entire property to the debtor and subjecting the entire property to the judgment or other lien.

Joint Tenancy Tax Ramifications:

• All owners file a Schedule E as an attachment to IRS Form 1040 to show their share of rental income and loss.

Tenants by Entirety (T by E) Advantages:

• The main advantage of holding title as tenants by the entirety is that upon the death of one spouse, nothing needs to be done, as the surviving spouse still owns the entire property.

Tenants by Entirety Disadvantages:

• Conveyance of the property must be done together by the married couple.

• In the case of divorce, this type of title automatically converts to a tenancy in common, meaning that one owner can transfer ownership of their respective part of the property to whomever they wish.

Tenants by Entirety Asset Protection:

• T by E ownership offers potentially significant asset protection, but can also be thwarted depending on which spouse dies first.

• If a creditor gets a judgment against one spouse only (for example, as a result of an automobile accident or a failed business), that judgment will not attach to the property so long as both spouses are alive. A judgment against just one spouse will not attach to T by E property; a creditor who has a judgment or other lien against one spouse can not ask the court to divide (partition) the property and force a sale in order to collect on its judgment or lien. However, a creditor with a judgment or other lien against one spouse can wait to see if the other spouse dies first, at which time the judgment against the surviving spouse immediately attaches to the entire property because the surviving spouse automatically becomes the owner of the entire property at that time. On the other hand, if the debtor spouse dies first, then the non-debtor spouse still owns the entire property and the lien against the debtor spouse will never attach to that property.

Tenants by Entirety Tax Ramifications:

• Married couples file their normal IRS Form 1040 and Schedule E.

Limited Liability Companies (LLCs)

LLCs are one of the most popular structures for holding rental real estate because starting and running an LLC is fairly simple and offers very valuable asset protection benefits not provided by any of the above forms of ownership. An LLC has the same powers as an individual to do all things necessary or convenient to carry out its business and affairs, including, without limitation, the power to sue or be sued in its name.

LLC Advantages:

• A limited liability company (LLC) is a type of entity that can help investors protect rental real estate and reduce the potential risk of lawsuits, and potentially shield the rental properties themselves from lawsuits.

• Owners of an LLC are typically called members and or managers, and property owned by an LLC is protected from lawsuits against the individual member(s) of the LLC. LLCs are business entities distinct from the members and may be easier and less expensive to create and manage compared to a corporation.

• An LLC can generally have an unlimited number of members, which may make an LLC a good vehicle to consider for group investing.

• Members of an LLC may provide equity capital, debt financing in the form of a loan to an LLC, or a combination of both.

• Single-member LLCs may be formed to hold rental property as an alternative to owning property in a personal name or “doing business as” (DBA) name.

• Income or losses from a rental property held in an LLC are passed through to each member and reported on individual tax returns, with income taxes paid based on each member’s individual rate, avoiding the double taxation of corporate profits.

• Members of an LLC also may buy and sell their individual shares without having to sell the actual rental property, based on the rules outlined in an LLC’s Operating Agreement.

LLC Disadvantages:

• Starting an LLC requires you to file Articles of Organization with the state, pay the required filing fees, including annual filing fees every year, maintain a registered office in the state, possibly pay local business taxes, sign an operating agreement, and abide by the operating agreement.

• LLCs are of course more complicated to operate than simply owning a property in your own name. You need to have a separate LLC bank account; you need to have a lease with the LLC named as the landlord, which may require amending your current lease; you need to have the tenants pay rent to the LLC; all expenses of maintaining the property must be paid by the LLC, except for the mortgage, if there is a mortgage, which should continue to be paid by you assuming the loan was taken out by you.

• If there’s a mortgage on the property, there’s a small chance that the lender could exercise the due-on-sale clause in the mortgage if they find out that you transferred the property to an LLC (they normally don’t find out unless you make the mistake of telling them or make the mistake of alerting them by paying the mortgage from the LLC). Historically, this has not been a problem so long as you continue making timely mortgage payments from your personal account as you have been, but there is some concern that in this day of rising interest rates lenders might be more likely to exercise the due-on-sale clause in order to force you to refinance the loan at a higher interest rate or to get lower interest rate loans off of their books.

LLC Asset Protection:

• LLCs are specifically designed to provide asset protection, but LLCs don’t always provide the protection that they are designed for, for various reasons. Here are some of those reasons:

1. Single-member LLCs have been attacked in many jurisdictions and no longer provide any asset protection in those jurisdictions. It is feared that these types of attacks may sweep across the country, rendering single-member LLCs useless for asset protection. Therefore, as a general rule, we do not recommend single-member LLCs.

2. If you don’t properly manage an LLC, you will likely lose the desired protection. For example, if you commingle LLC assets with personal assets, or if you don’t treat the LLC as a legitimate separate business entity, then someone suing the LLC can also sue you personally, claiming that the LLC was not a legitimate entity, but rather was a sham, or your alter ego.

3. An LLC might protect a rental property from lawsuits, but it might not. To understand this, it is important to understand the difference between “outside attacks” and “inside attacks,” which is especially important if you own multiple rental properties.

Outside Attacks vs. Inside Attacks Against an LLC

Real estate owned by an LLC can be attacked from two different directions — lawsuits against an individual member of the LLC (known as an outside attack), and lawsuits against the LLC itself (known as an inside attack).

Outside Attacks: Real estate can be attacked by an outside lawsuit, meaning a lawsuit against a member of the LLC arising from activity taking place outside of the LLC, such as a lawsuit arising from a vehicle collision where a member of the LLC is found to be at fault. Let’s say you have three rental properties inside one LLC and are attacked via an outside lawsuit such as a lawsuit arising from an automobile collision. In this situation, injured individual(s) I will be filing a lawsuit against you as an individual because you were driving the vehicle that allegedly caused the collision. If you are found to be at fault in the lawsuit, and if a judgment is entered in excess of your auto insurance and umbrella insurance liability limits, this judgment will attach to all assets that you own personally. This judgment will not attach to the assets owned by the LLC, so in this situation, the assets owned by the LLC are protected from liability, provided you have properly managed the LLC by running it as a separate business, not commingling business assets with personal assets, etc.

Inside Attacks: Real estate can be attacked by an inside lawsuit, meaning a lawsuit against the LLC itself arising from activity taking place inside of the LLC. For example, let’s say you have three rental properties (let’s call these Rental 1, Rental 2, and Rental 3), and there is an electrical fire in Rental 1 in the middle of the night, killing or injuring the occupants of Rental 1. The injured occupant(s), or the estate(s) of the deceased occupant(s), will file a lawsuit against the owner of the property, meaning a lawsuit against the LLC. If the LLC is found to be negligent in the lawsuit, for example, because of faulty electrical wiring that the LLC should have known about, and if a judgment is entered in excess of the LLC’s liability and umbrella insurance limits, this judgment will attach to all assets that are owned by the LLC. In this situation, the judgment against the LLC will attach to all three rental properties owned by that LLC, exposing them all to a potential judgment sale.

Protection from Inside Attacks Using Multiple LLCs

Because of the above risk of inside attacks, I recommend that all my clients who own multiple rental properties own each rental property in its own separate LLC in order to insulate each property from inside liability attacks against one property that could attach to all other properties owned by the same LLC, such as in the electrical fire example above. For example, let’s assume you own the same three separate rental properties as in the above example, but instead of all three being owned by one LLC, each rental property is owned by a separate LLC. Rental 1 is owned by Rental 1 LLC, Rental 2 is owned by Rental 2 LLC, and Rental 3 is owned by Rental 3 LLC. Now assume the same electrical fire happened inside of Rental 1. The injured occupant(s), or the estate(s) of the deceased occupant(s), will, as in the example above, file a lawsuit against the owner of the property, meaning a lawsuit against Rental 1 LLC. If Rental 1 LLC is found to be negligent in the lawsuit because of faulty electrical wiring, and if a judgment is entered in excess of Rental 1 LLC’s liability and umbrella insurance limits, this judgment will attach only to the property owned by Rental 1 LLC, meaning the judgment will attach only against Rental 1 and will not attach to Rental 2 or Rental 3. Because each property is owned by a separate LLC, the judgment against one LLC will not attach to the properties owned by the other LLCs. Typically, for extra simplicity when collecting rent and managing the properties, and for even greater asset protection, I recommend that owners of multiple rental properties own each property in a separate LLC and have another separate LLC to act as the “Master LLC / Property Management LLC.” This master LLC usually owns the other LLCs (which might all be called sub-LLCs underneath the master LLC) and acts as the property manager to collect rent and pay all of the expenses for all of the sub-LLCs.

LLC Tax ramifications:

Single-member LLCs: A single-member LLC is considered a “disregarded entity” by the IRS, so no separate tax return needs to be filed. As an individual owner of a single-member LLC, you file Schedule E as an attachment to IRS Form 1040 to show your rental income and loss. Thus, from a tax perspective, having a single-member LLC keeps things as simple as possible.

However, as mentioned above, single-member LLCs have been attacked in many jurisdictions and no longer provide any asset protection in those jurisdictions, and it’s feared that these types of attacks may sweep across the country, rendering single-member LLCs useless for asset protection.

Therefore, again, as a general rule, we do not recommend single-member LLCs, unless the single member is a Multi-Member LLC or irrevocable asset protection trust.

Multi-Member LLCs. The default rule is that a multi-member LLC is taxed as a partnership, even if the owners are a married couple. This requires the filing of an IRS Form 1065 partnership tax return and an IRS Form 8825 to report income, deductible expenses, and losses.

Our typical recommendation for owners of rental property is to have one “Master LLC,” owned by multiple members such as a husband and wife, or a parent and child(ren). This Master LLC will be the sole owner of each additional “sub-LLC,” each of which owns one rental property. The Master LLC also serves as the property manager for the other LLCs.  Rent from each of the sub-LLCs will be assigned to and collected by the Master LLC and all expenses in connection with all the sub-LLCs will be paid for by the Master LLC. This way, the master LLC with multiple owners files a partnership tax return, but the sub-LLCs, because they are owned by the Master LLC, are considered single-member LLCs and are therefore disregarded entities that do not need to file tax returns, as their activities are all combined and reported on the Master LLC’s partnership tax return.

Alternatively, an LLC can file a tax election using IRS Form 8832 and choose to be taxed as a C Corporation and then file IRS Form 2553 to elect to be taxed as an S Corporation. There is typically no tax or protection benefit to the S Corp election, but some accountants are more comfortable filing S Corp tax returns than partnership tax returns, as partnership tax returns sometimes require complex calculations and adjustments of each partner’s basis due to income, contributions, new partners, and more.

Living Trust Plus® Asset Protection Trust for Rental Property

The Living Trust Plus® is a special type of irrevocable asset protection trust that functions very similarly to a revocable living trust and maintains much of the flexibility of a revocable living trust but provides even better protection than an LLC because it protects your assets from probate PLUS lawsuits PLUS long-term care expenses while you’re alive by helping you be able to qualify for Veteran’s Aid and Attendance benefits after 3 years and Medicaid benefits after 5 years. An LLC does not protect your assets from probate or long-term care expenses, which is why many people choose the Living Trust Plus to protect their rental property.

Living Trust Plus Advantages:

• The Living Trust Plus doesn’t get filed with the State, so it offers greater privacy protection and there are no filing fees.

• After the Living Trust Plus is created, there are no recurring annual fees to maintain the trust as there are with an LLC.

• The Living Trust Plus provides lifetime management of your assets if you become incapacitated, and distributes your assets to your desired beneficiaries upon your death, either outright or and further asset protection sub-trusts for each of your beneficiaries. The Living Trust Plus is a complete estate planning solution, which is not the case with an LLC.

• The Living Trust Plus avoids the lengthy and complex and expensive probate process because it, rather than an individual, has ownership rights to the rental property held in the trust, and the trust, not the probate court, distributes the assets to your beneficiaries.

Living Trust Plus Asset Protection:

• Like an LLC, the Living Trust Plus Asset Protection Trust protects your rental property from “outside” attacks such as auto accident lawsuits and other outside creditor attacks.

• If you have multiple rental properties, having a separate Living Trust Plus for each property, just like having a separate LLC for each property, will protect your other assets from “inside” attacks.

• What makes the Living Trust Plus better than an LLC for many people, especially those who don’t have long-term care insurance (or don’t have sufficient long-term care insurance), is the Living Trust Plus also protects your rental properties from the catastrophic expenses often incurred in connection with assisted living and nursing home care.

• For most Americans, the Living Trust Plus Medicaid Asset Protection Trust is the preferable form of asset protection trust because, for purposes of Medicaid eligibility, this type of trust is the only type of self-settled asset protection trust that allows a settlor to retain an interest in the trust while also protecting the assets from being counted by state Medicaid agencies.

• Even though the Living Trust Plus Asset Protection Trust is “irrevocable” by the Settlor(s) acting alone, it can still be terminated so long as the trustee and all of your beneficiaries agree to terminate it.

Additionally, you retain a very high degree of control over your trust assets because:

1. you (and your spouse) can be the trustee(s) if desired, which means you retain investment control over the assets, including the right to sell any trust-owned real estate and any financial asset owned by the trust, with the proceeds from said sale staying in the trust and you, as trustee, retaining the ability to use those assets to purchase alternate assets owned by the trust;

2. you retain the right to live in and use your real estate;

3. you retain the right to change trustees; and

4. you retain the right to change beneficiaries.

Living Trust Plus Disadvantages:

• Unlike an LLC, which by its nature is revocable (meaning you can terminate the LLC at any time and take your rental property out of the trust at any time), the Living Trust Plus is irrevocable, meaning that you (or you and your spouse), acting alone, cannot revoke the trust, and cannot take your rental property out of the trust.

• The Living Trust Plus may not be a good solution for people who do not have trusted adult children.

• Because a trust is not a business entity like an LLC, the Living Trust Plus is not designed to hold an actively-run business other than a passive rental real estate business.

• A trust is more complicated and expensive to set up compared to an LLC, in part because it is much more complex and provides much greater protection.

Living Trust Plus Tax ramifications:

• Because it is an irrevocable trust, we will obtain a separate tax ID number for your Living Trust Plus, and the trust will need to file an annual IRS form 1041 informational tax return along with a grantor trust statement. These are very simple forms to file, whether you do them on your own or have your CPA file them for you.

• The Living Trust Plus is taxed as a grantor trust, meaning that all income, deductions, credits, and losses pass through to your 1040.

• For married couples owning rental property, one of the biggest advantages of the Living Trust Plus, as opposed to an LLC, is that married couples are not required to be taxed as a partnership and therefore will not have to file an IRS Form 1065 partnership tax return and an IRS Form 8825 to report income, deductible expenses, and losses. Rather, a married couple can file their normal 1040 tax return (and the 1041 informational return mentioned above) along with Schedule E, and on Schedule E the married couple can simply check a box to make a Qualified Joint Venture (QJV) election for each rental property.

The Farr Law Firm Helps Protect Our Clients’ Assets and Quality of Life

It is important to protect yourself, your quality of life, and your golden years with estate planning, long-term care planning, and financial planning. Besides being a Certified Elder Law Attorney, Evan Farr is also an experienced retirement planning advisor and long-term care financial advisor.

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