Real estate investments can be a great way to build wealth, but you need to plan your taxes and manage your estate well.
One good solution is to hold real estate in a Limited Liability Company (LLC) that is taxed as a partnership. This gives you a lot of advantages when it comes to income tax and estate tax.
This comprehensive guide looks at these benefits, focusing on pass-through taxation, flexible profit and loss allocations, deductions, depreciation, cost segregation, and step-up basis, and it gives real-world examples to show how the ideas work.
1. Help With Taxes on Income
Taxation on Pass-Through:
LLCs that are taxed as partnerships have their income, losses, deductions, and credits flow through to the personal tax returns of each member.
This structure gets rid of double taxation and lets members take advantage of lower individual tax rates and the 20% QBI deduction.
Example: An LLC with $200,000 in annual rental income can avoid the 21% federal corporate income tax ($42,000) and subsequent dividend taxation by being taxed as a partnership, passing the income directly to the members, and possibly benefiting from lower individual tax rates and the 20% QBI deduction.
Flexible Ways to Split Profits and Losses:
LLCs that are taxed as partnerships can split profits and losses among members however they want, as long as the splits have a big effect on the business’s finances.
This gives members the freedom to spread out their profits and losses in a way that minimizes their overall tax burden.
Example: Instead of strictly adhering to ownership percentages, an LLC with three members (A: 50%, B: 30%, and C: 20%) distributes a larger portion of the $100,000 profit to Member C, who is in a lower tax bracket if the operating agreement states that a larger portion of the profits are to be allocated to Member C.
Tax Deductions, Depreciation, and Cost Segregation:
On their personal tax returns, LLC members can claim their share of the LLC’s operating costs, interest, and depreciation.
Good depreciation rules, like the Modified Accelerated Cost Recovery System (MACRS) and bonus depreciation, are often good for real estate investments.
Cost segregation is an advanced tax strategy that can increase depreciation deductions by putting different parts of a property into categories with shorter depreciable lives.
Example: An LLC acquires a commercial property for $1,000,000. With cost segregation, the LLC reclassifies 20% of the property’s value into 5, 7, and 15-year property classes. This raises the first-year depreciation deduction from $25,641 (straight-line) to $70,000. (accelerated depreciation).
2. Estate Tax Benefits and Step-Up Basis
Estate Tax Planning:
Holding real estate in an LLC that is taxed as a partnership makes estate planning easier because members can give their shares of the LLC to their heirs. This could help avoid probate and give more options for how assets are distributed.
This structure also makes it possible to use more advanced estate planning techniques, such as gifting interests using the annual gift tax exclusion or the lifetime gift tax exemption.
- A father who is a member of an LLC gives his share of the business to his two children, either while he is still alive or after he dies. By doing this, he avoids probate if certain clauses are in the LLC operating agreement and can minimize estate taxes by using annual gift tax exclusions or the lifetime gift tax exemption.
The step-up basis is one of the most important estate tax benefits for the heirs of LLC members who have died. When a member dies, the basis of the interest he or she left in the LLC’s real estate is raised to the property’s fair market value (FMV) at the time of death.
This means that the heirs will have to pay less in capital gains tax when they sell the property in the future.
- One member of an LLC spent $300,000 to buy a rental property. In time, the value of the property goes up to $600,000. When a member dies, the property interest goes to the member’s heir. With the step-up basis, the heir’s basis in the property is changed to $600,000, which is the property’s FMV. If the heir later sells the property for $650,000, they would only have to pay capital gains tax on $50,000 ($650,000 – $600,000) instead of $350,000 ($650,000 – $300,000).
- Also, if the property is subject to depreciation, the heirs can claim deductions for depreciation based on the new, higher basis. This can help the heirs save more money on taxes. For example, if the inherited property is a commercial building, the heir can use the stepped-up basis of $600,000 instead of the original basis of $300,000 to claim depreciation deductions over 39 years.
Having real estate in an LLC that is taxed as a partnership gives you a number of income tax and estate tax benefits that can make property investments much more profitable.
Investors can save the most money on taxes and make estate planning easier by using pass-through taxation, flexible profit and loss allocations, deductions, depreciation, cost segregation, and the step-up basis in a smart way.
This detailed guide with real-world examples is a great tool for investors who want to get the most out of the benefits of holding real estate in an LLC taxed as a partnership.