h/w rental LLC questions

[kathyc2]

I have a client currently residing in MD looking to buy a rental investment property in IN. I have a couple questions/verifying on understanding that I'd appreciate someone checking me on before I answer some of their questions.

They want to set up a LLC. Since neither state is a community property state, the default will be a partnership return, correct?

They will be getting the down payment from a HE loan on their primary residence. Because it would not be a debt of the LLC, should that interest be on Sch A?

I believe that banks charge a higher interest rate if an LLC but I'm not finding anything legitimate to confirm that belief.

If they want to convert the rental to primary residence in a few years what would be the tax treatment? IOW, if it's owned by an LLC would it be different than if they just personally owned it?

[TaxGuyBill]

I'm not good with Partnerships, but I'll take a stab at things:

Yes, it would need to be on a 1065.

I would THINK it would be on Schedule A, and the loan amount would be a capital contribution to the Partnership. However, be aware the the Home Equity limit is $100,000.

If the bank loaned money to the LLC (which is not the case), it could be a higher interest rate because of the Limited Liability aspect (the LLC would file bankruptcy and the bank would be out of the money). However, in many (or most) cases, the bank also makes the LLC member liable for the loan, which would negate any reason for a higher interest rate. At any rate, the bank is not loaning to the LLC, so that should not matter.

I THINK the bottom line would be the same as if they had personally owned it. It would be more paperwork on the final LLC form for Partner distributions, but I THINK the bottom line would be the same.

[taxea]

Check the rules, if they are married they may be able to file the rental on their 1040 Sch E as a disregarded entity. The LLC would be for liability purposes only.
It is not in their best interest to tie the purchase to their personal residence. Research the rules to see whether they would be able to structure the purchase so that the mortgage/purchase is separate from the personal residence mortgage.

[TaxGuyBill]

From what I'm reading, the "tracing" rules say the interest can be on Schedule E, and not be limited to $100,000.

http://www.thetaxadviser.com/issues/2014/jul/case-study-july2014.html

[kathyc2]

Check the rules, if they are married they may be able to file the rental on their 1040 Sch E as a disregarded entity. The LLC would be for liability purposes only.

My understanding is that is only available in community property states: "Note: If an LLC is owned by husband and wife in a non-community property state, the LLC should file as a partnership. LLCs owned by a husband and wife are not eligible to be "qualified joint ventures" (which can elect not be treated as partnerships) because they are state law entities." https://www.irs.gov/Businesses/Small...lity-Companies

[kathyc2]

From what I'm reading, the "tracing" rules say the interest can be on Schedule E, and not be limited to $100,000.

http://www.thetaxadviser.com/issues/...-july2014.html

I think you misunderstood. They are not financing the rental purchase w/ a HE, only the down payment portion. They would then have a rental mortgage for the other 80%.

I would agree w/ the tracing if filing Sch E. However, with it being an LLC I don't think the down payment portion would qualify since it's a personal loan rather than an LLC loan. Taking it as a Sch A deduction would benefit them more actually. Although they would miss the state deduction, I can't see that it will show any tax profit- at least not for a long time- and their income is high enough that they can't take a passive loss.

I'm not a big fan of an LLC for a rental property and that may be clouding my thinking...

[TaxGuyBill]

Yes, I did misunderstand. Sorry for my confusion. :-)

[mactoolsix]

My understanding is that is only available in community property states: "Note: If an LLC is owned by husband and wife in a non-community property state, the LLC should file as a partnership. LLCs owned by a husband and wife are not eligible to be "qualified joint ventures" (which can elect not be treated as partnerships) because they are state law entities." https://www.irs.gov/Businesses/Small...lity-Companies

I agree, but maybe this "workaround" would help . . .
Instead of the LLC, which I presume is for liability protection, we recommend the clients take out an umbrella policy. In CA (community property) LLCs cost $800 @ year plus the cost of another tax return if a partnership; umbrella policies are a couple hundred.

If they really want an LLC, have one be a member of the LLC and have the attorney spell out the inheritance to the other in their trust documents. This way it would be a disregarded entity - much simpler. If the untitled spouse dies first, no step-up; but that's a chance they may consider taking. Change the title when they make it their primary residence.

Mike

[mactoolsix]

Whether they use an LLC or not, the interest on the HELOC should be traced back to the rental on Sch E. And you need to file an election.

[kathyc2]

I agree, but maybe this "workaround" would help . . .
Instead of the LLC, which I presume is for liability protection, we recommend the clients take out an umbrella policy. In CA (community property) LLCs cost $800 @ year plus the cost of another tax return if a partnership; umbrella policies are a couple hundred.

If they really want an LLC, have one be a member of the LLC and have the attorney spell out the inheritance to the other in their trust documents. This way it would be a disregarded entity - much simpler. If the untitled spouse dies first, no step-up; but that's a chance they may consider taking. Change the title when they make it their primary residence.

Mike

Yes, I gave them the info re if only one is a member how they can just put it on Sch E. Are you saying that if it was an asset of a LLC and they decide later to have it as their primary residence, they can just change the title without tax consequence even if it has increased in value? That seems counter intuitive to me as it would be moving from a separate legal entity to personal.

[taxea]

I think you misunderstood. They are not financing the rental purchase w/ a HE, only the down payment portion. They would then have a rental mortgage for the other 80%.

I would agree w/ the tracing if filing Sch E. However, with it being an LLC I don't think the down payment portion would qualify since it's a personal loan rather than an LLC loan. Taking it as a Sch A deduction would benefit them more actually. Although they would miss the state deduction, I can't see that it will show any tax profit- at least not for a long time- and their income is high enough that they can't take a passive loss.

I'm not a big fan of an LLC for a rental property and that may be clouding my thinking...

I agree with your last statement. Why do this when the IRS doesn't consider the rental a "business". It is normally done for liability purposes.
They can use a Promissory Note from them (loan to business) to LLC that includes all terms of payment, etc. They can charge interest on the loan and the business would pay principal and interest (expense). They would only have to report the interest as income on their personal return. This way the equity loan is not tied to the business. i.e. business pays to them, they then pay the equity loan with personal funds not directly from the LLC.

From Pub 17 on Partnerships:
Publication 541, Partnerships.
Qualified joint venture. If you and your
spouse each materially participate as the only
members of a jointly owned and operated business,
and you file a joint return for the tax year,
you can make a joint election to be treated as a
qualified joint venture instead of a partnership.
To make this election, you must divide all items
of income, gain, loss, deduction, and credit attributable
to the business between you and your
spouse in accordance with your respective interests
in the venture. For further information on
how to make the election and which schedule(
s) to file, see the instructions for your individual
tax return

This says nothing about applying to community property states only. They can do a Sch E on their 1040.

[kathyc2]

I agree with your last statement. Why do this when the IRS doesn't consider the rental a "business". It is normally done for liability purposes.
They can use a Promissory Note from them (loan to business) to LLC that includes all terms of payment, etc. They can charge interest on the loan and the business would pay principal and interest (expense). They would only have to report the interest as income on their personal return. This way the equity loan is not tied to the business. i.e. business pays to them, they then pay the equity loan with personal funds not directly from the LLC.

From Pub 17 on Partnerships:
Publication 541, Partnerships.
Qualified joint venture. If you and your
spouse each materially participate as the only
members of a jointly owned and operated business,
and you file a joint return for the tax year,
you can make a joint election to be treated as a
qualified joint venture instead of a partnership.
To make this election, you must divide all items
of income, gain, loss, deduction, and credit attributable
to the business between you and your
spouse in accordance with your respective interests
in the venture. For further information on
how to make the election and which schedule(
s) to file, see the instructions for your individual
tax return

This says nothing about applying to community property states only. They can do a Sch E on their 1040.

QJV is only for business that is neither a corp or an LLC.

[mactoolsix]

Yes, I gave them the info re if only one is a member how they can just put it on Sch E. Are you saying that if it was an asset of a LLC and they decide later to have it as their primary residence, they can just change the title without tax consequence even if it has increased in value? That seems counter intuitive to me as it would be moving from a separate legal entity to personal.

NO - I'm saying they should dissolve the LLC when they move into the rental as a primary rental. If only a few years have passed, there would be minimal gain. There is no benefit in using an LLC for a primary residence.