You can create a separate entity to own business real estate and rent it to an operating company. Typically, a business owner gets more out of his or her business by renting or leasing property to it. However, it is often advantageous to hold the rented property in a separate entity, such as a limited liability company (LLC) or a partnership. By creating a separate entity, you may be able to limit liability, minimize tax liability, potentially lower the risk of an IRS audit, and facilitate the transfer of the property to your heirs upon your death.
Limiting Liability
If you buy property and rent it to your business, then you could become personally liable if, for example, someone was injured on the premises. You could put your life savings, your home, and all the rest of your assets at risk. If, however, the property is purchased and owned by an LLC or a corporation, then generally you are only risking the amount that you have invested in the entity. In general, you avoid personal liability for most claims.
Caution: Liability insurance may protect you from some risk, but injury claims could exceed the limits of your coverage. Moreover, if your business is involved in hazardous or ultrahazardous operations (such as fireworks production), then you may not be able to obtain liability insurance at all. In addition, insurance may not cover losses that are the result of fraud or bad faith.
Minimizing Family Tax Liability
If you own property and rent it to your company, the rental payments are income to you. You must pay income tax on the amounts received. If, however, you create a partnership made up of you and your adult child, the partnership can buy the real estate and lease it to your business. The rental payments will be made to the partnership. Partnerships are pass-through entities for tax purposes, meaning that income to the partnership is taxed at the individual partner level. If your adult child is in a lower tax bracket than you, then your family will likely minimize its overall tax liability. The share of partnership income attributable to your child will be taxed at his or her lower personal rate.
Potentially Lower Audit Risk
When you buy real estate and rent it to your company, you must separately list the rental income and expenses on Page 1 of Schedule E of your personal tax return. Due to potential abuses, the IRS may flag rental income when it appears this way. This may be less likely to happen when the rental income is channeled through a separate entity and listed as a single-line item of income on your return.
Facilitates Estate Planning
Simplifies Probate
If you die and leave a parcel of real estate to multiple heirs, the property could be held up in probate for months. Transferring real property out of an estate to multiple heirs involves a number of complications, especially if your heirs are to receive unequal interests in the property. If the real estate is held by a corporation, then only the shares of stock need to pass through probate. The estate merely issues to each heir a number of stock certificates proportionate to his or her intended bequest.
Simplifies Subsequent Transfer of Property by Heirs
If your heirs are likely to sell the property, they are better served if the property is held by an entity. For example, to sell a piece of real estate held by a corporation, you only need a vote of the board of directors authorizing the action. You should be aware, however, that under certain state laws, if the piece of real estate is all or substantially all of the assets of the corporation, a shareholder vote may be required to authorize the sale. In contrast, if you have 12 heirs and each owns a portion of the real estate, then they must all sign the deed before the property can be sold. Getting 12 heirs to agree on a sale price will be only the beginning of the difficulties. Just getting all 12 heirs in the same place at the same time to conduct a closing can be a huge problem.
May be Able to Avoid Estate Taxes
If you hold real estate in an entity, you may be able to avoid estate taxes. If you transfer the property during your lifetime through a trust, of if you place the property into a corporation and gift shares to your heirs during your lifetime, then the real estate, and ownership of the entity, will pass outside of your estate and will not be subject to estate taxes. (Of course, the lifetime gifts of the shares will be subject to the regular gift tax rule.)
If you have questions, contact the experts at Henssler Financial: 770-429-9166 or experts@henssler.com.