When it comes to real estate investment in California, a common question that comes to mind is whether to use a California Limited Liability Company (LLC) for investment property.
In this article, we delve into the intricacies of using a California LLC for real estate in California, discussing its benefits, drawbacks, and the legal implications involved. This will provide a guide to help you make an informed decision aligned with your financial goals and risk tolerance for your real estate investments.
Benefits of Forming a California LLC for Rental Property
Forming a California LLC for your real estate holdings in California comes with a multitude of advantages worth considering.
These benefits range from legal protections and tax efficiencies to potential ease in managing and transferring your real estate.
In the following sections, we will provide an overview of these benefits, painting a picture of why many investors create a California LLC for their investment property.
Asset Protection and Liability Limitation
Perhaps the most compelling advantage of creating a California LLC for rental property is the significant level of asset protection it provides.
Separation of Personal Assets from Real Estate Holdings
When you form a California LLC for real estate, your personal assets are shielded from liability in the event of a lawsuit or debt incurred by the rental property. For instance, if a tenant were to file a lawsuit related to the property, only the assets owned by the California LLC (i.e., investment property the California LLC owns) would be at risk, and not your personal assets, such as your home, car, or personal savings.
The liability protection created by this separation of business and personal assets is often referred to as a corporate veil. Creating a California LLC is a powerful tool for real estate investing in California given the litigious nature of the state and its legal traditions of hostility against landlords. In many cases, the significant asset protection offered by a California LLC makes it a preferred choice for property investors in California.
Liability Limitation
Apart from asset protection, another pivotal benefit of using a California LLC for real estate in California is the limitation on liability.
The term “limited liability” in Limited Liability Company is not just a fancy title—it is a legal provision that restricts your personal liability in matters related to real estate investing. More specifically, if your California LLC faces bankruptcy or lawsuits, your personal liability may be restricted to the extent of your investment in the California LLC.
In other words, creating a California LLC separates your personal assets outside of the LLC from the assets within the LLC, and you should not be called upon to cover the rental business debts, liabilities, obligations, or legal judgments against the California LLC from your personal assets. This liability limitation is particularly beneficial in a state like California where real estate investments can be sizable and the risk of litigation is high.
Protections Against Liens Against Identically Titled Properties
In California, one significant risk faced in real estate investing as an individual or through a trust is the potential for a lien against one property being extended to all identically titled properties.
Liens are usually placed by creditors as a claim on a property to secure payment of a debt, but they may also be placed by contractors who render services to repair or upgrade properties. If one property is encumbered by a lien, it could potentially impact all properties held under the same name. For instance, if you own three different properties in your name and a lien is placed on one of them due to a legal judgment or unpaid debt, it is possible that the lien could affect all three properties.
In contrast, with a California LLC, each property can be held in a separate LLC. If separate LLCs are used, and if a lien were to be placed on one property within one LLC, it would not impact any other properties held in different LLCs.
This arrangement provides an additional layer of protection, particularly for those with multiple properties or significant real estate investments. Of course, this requires the formation of separate LLCs for each property, and having separate LLCs for each property does not come without cost.
Personal Liability Protection Among Members
A California LLC also provides personal liability protection through a mechanism called charging order protection, which protection is far superior to holding properties with co-owners as joint tenants or tenants in common.
Should one of the members of an LLC face personal creditors or a legal judgment, those creditors cannot directly reach the assets of a California LLC, including rental properties. Instead, what the creditors get is a charging order, which is a lien on the distributive share of the LLC profit interest of the debtor-member. This means that creditors are only entitled to the share of the profits of the debtor-member if and when they are distributed, but the creditor does not become a member, does not have a stake in management, does not have a right to ask a court to dissolve the LLC, or any other rights usually associated with membership in a California LLC, thus protecting the investments of other members from the creditors of the debtor-member.
Ownership and Management by a Trust
Trusts Generally Do Not Provide Asset Protection or Limited Liability
While trusts can be utilized in managing real estate properties, it is important to note that most types of trusts do not provide the asset protection or liability limitation that a California LLC provides.
Trusts, in their traditional form, primarily serve estate planning purposes, such as avoiding probate, providing privacy in estate planning, and possibly helping with tax planning, but they do not typically shield personal assets or limit personal liability.
That is not to say that trusts should not be used by real estate investors, because they absolutely should be used, but as the sole member and manager of the LLC, and not to hold real property directly.
Limitations on a California LLC for Privacy and Anonymity
A California LLC can provide a degree of privacy and anonymity by separating the names of owners from the properties owned. However, a quick search of the California Secretary of State business entity database would quickly uncover the names of the LLC members or managers based on the name of the LLC property owner and the required Statement of Information that must be filed after creating a California LLC and biennially thereafter.
Many real estate investors consider forming a real estate LLC in another state which offers more anonymity than California, but if the real estate investor or the property is located in California, that LLC formed in another state will have to register for Authority to Transact Business in California, resulting increased operational expenses, the requirement to pay taxes in another state and California, and still requiring disclosure of the identities of the member of the LLC in the Statement of Information in California.
Enhanced Privacy and Anonymity Using a Trust as a Member of the LLC
Utilizing a trust as the member or manager of a California LLC can provide a significant layer of privacy and anonymity for owners of rental properties in addition to their inherent estate planning benefits.
A trust, being a separate legal entity, can be established in such a way that the individual owners or beneficiaries of the properties are not publicly disclosed. Trusts are private documents, and they need not be filed or made publicly available, so they do not become public records. Furthermore, the name of a trust need not identify the trustees or beneficiaries (although many revocable living trusts are titled this way).
When a trust is the member or manager of a California LLC, it is the name of the trust that appears on public documentation such as the Statement of Information rather than the names of individual persons, and Statements of Information may be signed by authorized signatories designated by the trustees, such as the corporate attorney filing the Statement of Information. This can help the beneficiaries of the trust maintain their anonymity as their personal information is kept separate from public records.
Just as the trust is a private document, so too is the California LLC Operating Agreement. The Operating Agreement is not filed with the California Secretary of State, thus the trustees who sign on behalf of the trust do not reveal their identities.
Consulting with a legal advisor is recommended when considering using a trust as a member or manager of a California LLC, and a trust document or Operating Agreement may be subject to a subpoena in a lawsuit, but this possibility is preferable to automatically becoming a public record.
Create a California LLC for Easier Transfers of Ownership
Creating a California LLC for your rental property can prove to be a huge benefit when the time comes to transfer ownership.
Transferring an LLC, Not the Property in an LLC
One of the significant advantages of using a California LLC for your rental property comes when it is time to transfer the property, either by sale or when passing ownership to heirs.
When a property is held in a California LLC, ownership can be transferred without changing the deed to the property. Instead, by simply changing the members of the California LLC, whether that be by purchase and sale, gifting, or by operation of trust to heirs, the identity of the members changes, but not the title to the property itself, which can be easier, faster, and potentially less costly than transferring the property deed.
Possible Avoidance of Reassessment for Property Tax Purposes
The process of transferring an interest in a California LLC versus transferring title to the underlying real estate can be particularly beneficial in avoiding transfer taxes and maintaining the original purchase price of the property as the assessed value for calculating property taxes.
Furthermore, transferring ownership within a California LLC can bypass the traditional sales process, thus avoiding complications associated with property sales such as inspections and appraisals. Hence, the use of a California LLC may simplify the process of property transfer, making it a preferred choice for real estate investors.
Potential for Perpetual Existence
In line with the possibility of transferring ownership of a California LLC instead of the underlying properties is the idea that the existence of a California may be perpetual.
The benefit of perpetual existence means that the California LLC survives even when a member leaves or passes away, making it an ideal business entity for rental property ownership and the creation of generational wealth.
As perpetual existence ensures the continuity of the business, providing stability and protection against unwanted dissolution and simplifying the process of transferring ownership, rental properties within a family or group of investors can pass on for generations under the same California LLC.
Form an LLC to Separate Personal and Business Finances
Establishing a California LLC for real estate separates personal finances from business finances with the use of a separate bank account.
With a California LLC, all the income and expenses related to the rental property are handled under the name of the business entity itself, including a bank account titled in the name of the California LLC. This means that the personal finances of the California LLC members remain distinct, providing clear financial boundaries and equal access to the bank account by all owners.
Moreover, having a separate business bank account simplifies bookkeeping and makes it easier to manage business expenses and income tax liabilities.
Easier Management and Decision Making
Not only does the real estate LLC Operating Agreement set forth that the California LLC owns the property, but setting up a California LLC can also provide for how rental income is distributed, how income tax liability is apportioned, and set forth requirements for the maintenance of property liability insurance, but can also be drafted to make sure management and decision-making easier among the managers of the California Limited Liability Company.
A California LLC Operating Agreement plays a vital role in streamlining management and decision-making processes for co-owners of rental property. This legally binding document outlines the operational procedures and ownership structure of the LLC, providing a clear guide on how key decisions should be made. It specifies the roles and responsibilities of each member, minimizing ambiguities and potential conflicts. This ensures that each member understands their rights in the decision-making process, reducing potential disputes and providing procedures for resolving disputes when they do arise.
Drawbacks of Using a California LLC for Rental Property
While a California LLC brings numerous benefits for rental property ownership, such as asset protection, liability protection, privacy and anonymity, and ease of transfer just to name a few, it is not without its drawbacks.
In the following section, we will delve into some of the potential challenges and disadvantages that come with using an LLC for rental properties.
Initial and Ongoing Costs
One of the primary drawbacks of using a real estate LLC in California is the initial and ongoing costs associated with maintaining the LLC status.
When you create a California LLC, there are filing fees, and for something as important as investing in real estate, likely attorney’s fees as well.
California Franchise Taxes
While the pass-through taxation from forming an LLC that is a sole member or multi-member real estate LLC can prove beneficial for income tax purposes, California LLCs pay taxes called franchise taxes.
All California LLCs are subject to an $800 annual franchise tax just for existing in the LLC business structure, regardless of income. This annual franchise tax can be substantial compared to the rental income generated by smaller properties or properties with high business expenses.
This stands in sharp contrast to owning rental properties in a sole proprietorship or general partnership where such costs are non-existent, but liability protection and many other benefits are also non-existent unless you create an LLC for your rental property.
The California LLC Fee
Another important aspect to take into account when establishing a real estate LLC in California is the California LLC Fee.
The California LLC Fee is an annual charge in addition to the $800 annual franchise tax imposed on LLCs operating in California. This is an incremental fee that increases as the gross income of the LLC rises. It starts at $900 for LLCs with incomes between $250,000 and $499,999 and can rise as high as $11,790 for LLCs with incomes of $5 million or more.
However, a California Limited Partnership would be the entity of choice if annual gross revenue was expected to reach the $250,000 California LLC Fee threshold, as discussed in another recent article you can read here.
Maintenance Requirements
Another potential drawback of using a California LLC for rental property ownership is the maintenance requirements that accompany this business structure.
California LLCs may incur additional costs for tasks like record-keeping, tax preparation, and the biennial Statement of Information filing with the California Secretary of State. These costs can add up over time and can significantly impact the profitability of a real estate LLC with modest rental income or high business expenses.
Neglecting these responsibilities can lead to penalties or, in extreme cases, dissolution of the LLC, exposing members to personal liability.
Difficulty in Obtaining Mortgage Financing
Residential Properties
Obtaining mortgage financing for residential properties under an LLC can be challenging.
Many traditional lenders are hesitant to finance real property held in an LLC due to perceived risks and complexities. As a result, the loan options available to LLCs are often limited and can come with higher interest rates and more stringent terms.
Consult with a real property attorney or other real estate professional regarding options for acquiring real property without an LLC and transferring the real property into a real estate LLC once financing is completed, as this is a standard practice in real estate investing, although it is usually contrary to loan terms.
Commercial Properties
When it comes to financing commercial properties, most lenders require the use of a single-asset entity, such as an LLC, for real estate investing.
This condition is predominantly due to risk management considerations. A single-asset entity ensures that the financed property is the only asset within the company. In the event of a loan default, the lender can readily seize the sole asset (the commercial property) without complications from other potential assets. This restriction also protects the lender from other liabilities that could arise if there is more than one property owned without a separate entity.
Not Beneficial for a Personal Residence
Utilizing a real estate LLC for a personal residence does not provide any significant benefits, and contrary to popular belief, does not provide tax benefits.
It is highly recommended to consult with a tax professional before you create an LLC for your personal residence.
When a California LLC is Absolutely the Wrong Choice for Rental Property
There are scenarios where establishing a California LLC for rental properties is inadvisable and could lead to more harm than good.
When Income from Rental Properties is Too Modest
If a rental property has a relatively modest income or high expenses limiting profitability, the cost to create an LLC as well as the annual franchise tax and other ongoing costs may outweigh the potential benefits of an LLC, even though those benefits are important.
When Gross Revenues Exceed $250,000 Annually
When the gross revenues of a rental property business exceed $250,000 annually, utilizing a California LLC becomes less advantageous due to the California LLC Fee.
When annual gross revenues exceed, or are in time expected to exceed, the $250,000 California LLC Fee threshold, a California Limited Partnership may be a more favorable alternative, as we discuss in depth here. California Limited Partnerships pay an annual franchise tax of $800 just like a California LLC, it is not subject to the California LLC Fee.
When the California LLC is Taxed as a Corporation or S-Corp
If you have a California LLC that has elected to be subject to double taxation like a corporation or taxed as an S Corporation with pass-through taxation, create an LLC from scratch before you complete your property purchase.
While the double taxation of corporate tax treatment and the S Corporation version of pass-through taxation might be good for actively operated businesses, they are not suitable for real estate investment because these particular tax classifications do not have access to capital gains taxation. Operating the rental properties under these circ*mstances may not present any immediate issues, however, should a decision be made to sell off a property, the lack of access to capital gains could subject the net profit of the sale to double taxation or rates on your tax return. There is no tax benefit to corporate taxation for real estate investment, so form an LLC disregarded for income tax purposes or LLC taxed as a partnership for your LLC’s assets to avoid treatment as business income versus capital gains tax treatment upon disposition of the investment property.
Changing the tax treatment of an entity subject to corporate form comes with additional tax consequences that could prove costly on your next tax return.
Final Thoughts on Using an LLC for Real Estate in California
In conclusion, forming a Limited Liability Company in California for investment property involves considerable thought and careful navigation through the complex state regulations and tax implications.
Whether you need a single-member LLC, a multi-member LLC, a manager-managed LLC, or even assistance with a private placement of membership interests, the corporate attorneys at San Diego Corporate Law are here to guide you. Our experienced corporate attorneys understand the intricacies of California LLC laws and have the expertise to ensure your California LLC formation is seamless and legally sound.
If you are seeking investors, we can help you navigate the private placement process as well, including the drafting of a private placement memorandum if required.
Do not navigate the complexities of California LLC formation alone – contact us today for assistance.
