LLC & Residence

[jmc]

My client with rental properties set up an LLC. Now, they ask me if it is better to put their residence also into the LLC.
Things I can think right now are as follows.
First, the asset, residence, can be protected from lawsuits with charging order protection.
Next, when filing LLC tax returns, mortgage interest and property taxes can be deducted as LLC expenses instead being reported as itemized deductions with phaseout limitations. Of course, $250000/$500000 gain exclusion will not be applied on LLC at sale.
Is it better to put the residence into LLC or leave it under personal names?
Is there any further potential issues?

[jainen]

tax evasion scheme

>>Is there any further potential issues?<<

Yes, there are, but before you move onto them I think you need to work a little more with the ones you already have.

Start with, "the asset, residence, can be protected from lawsuits." More than likely, putting non-business assets into the LLC would instead destroy any protection they may have had for the rental property.

As to, "mortgage interest and property taxes can be deducted as LLC expenses," you know that's nonsense. The LLC can only deduct ordinary and necessary expenses of the rental business. Any use of business funds for personal benefit must be treated as a dividend, draw, or other distribution.

This is all a bigger problem for you than for the taxpayers. They would probably only have an underpayment with penalties and interest. You could face IRS sanctions and a civil suit for signing off on such a patently improper tax evasion scheme.

[jmc]

NOT &quot;tax evasion scheme&quot;

My intention the post was to ask for help by sharing with colleagues, when my brain does not work properly and could not think clearly on a Friday afternoon. I did NOT initiate the post with any intention of "tax evasion scheme". Please refrain from using abusive words.

Charging order protection is LLC's one of the biggest advantages against other entities, which you may need more research on.

[thomtax]

Charging order protection

I'm a long way from an expert on LLCs, but what does this mean? I have never seen this phrase before.

Second - to show my ignorance, the first thought in my mind is how do you put a personal item in a business, legimately? You did not say, but were they planning to pay a fair market rent to the LLC for their home?

LT

[thomtax]

Charging order protection

I'm a long way from an expert on LLCs, but what does this mean? I have never seen this phrase before.

Second - to show my ignorance, the first thought in my mind is how do you put a personal item in a business, legimately? You did not say, but were they planning to pay a fair market rent to the LLC for their home?

LT

[jmc]

There is a great article on charging order protection from Cal CPA Magazine on August 2005.

http://www.calcpa.org/californiacpa/articles/2005/0804.html

[thomtax]

Thanks for the link to the article. Your profile does not show where you are located. If I had realized it was California, I would probably not have asked any questions.

I am still curious about the answer to the question I had in the previous post about rent? I am always trying to further my knowledge.

[veritas]

Here is a possible reason

to not put a personal residence in a LLC.


CCM 200029046: The Office of Chief Counsel advised that where a taxpayer and his spouse formed a limited partnership with a family- owned LLC as the general partner to hold their personal residence, the taxpayers cannot exclude gain from its sale. Because the residence is owned by the partnership rather than the taxpayers, the taxpayers are not considered to have owned and used the property as their principal residence for a two-year period prior to sale. Code Section 121.

[jainen]

low blood sugar

>>could not think clearly on a Friday afternoon<<

Was this a low blood sugar thing, or were you distracted by prospects of a hot date? It doesn't take much brain power to understand the fundamental violation of mischaracterizing personal living expenses as business deductions.

With a little more energy you can remember that advising clients on how to hold title is one of the riskiest traps, even for an attorney (for whom it would at least be legal). Comingling personal and business assets is one of the surest ways to destroy the liability shield you hoped the LLC might provide.

If you think my words are abusive, wait 'til you hear what your client will say to you by this time next year.

[veritas]

My client with rental properties set up an LLC. Now, they ask me if it is better to put their residence also into the LLC.
Things I can think right now are as follows.
First, the asset, residence, can be protected from lawsuits with charging order protection.
Next, when filing LLC tax returns, mortgage interest and property taxes can be deducted as LLC expenses instead being reported as itemized deductions with phaseout limitations. Of course, $250000/$500000 gain exclusion will not be applied on LLC at sale.
Is it better to put the residence into LLC or leave it under personal names?
Is there any further potential issues?

Are you kidding? No section 121 exclusion and that's ok with you. What is the big deal about limited liabilty? Who are your clients, The Sopranos?

[S T]

did a Google Search

Well as odd as it sounds and does not compute in our "tax minds" I did find some info on placing the personal residence into a LLC. From http://www.llcloan.com/cont_entity.html

Should You Create an LLC for Your Primary Residence ? Usually the first question is what about the mortgage interest deduction? A properly-formed and current LLC holding your primary residence (and only your primary residence) is an excellent asset protection strategy for a very important asset! If you have created your LLC correctly, the mortgage-interest deduction can flow directly onto the individuals' tax return.

Now I don't know what the statement means "if you have created your LLC correctly".

From http://en.wikipedia.org/wiki/Asset_protection

Personal Residence

No asset is more important to shield from creditor claims than a personal residence. Personal residences represent the bulk of many people's fortunes, and have great sentimental value.

Creditors do not pursue the residence itself, but the equity in the residence that can be converted into money through a foreclosure sale of the residence. There are two equity stripping techniques.

One way to strip out the equity is by obtaining a bank loan. Even if we assume that a bank would lend an amount sufficient to eliminate 100% of the equity, the cost of this asset protection technique is staggering. A $1 million loan bearing a 7% interest rate, costs $70,000 per year.

Another way to strip out the equity (frequently advocated by clients), is to encumber the residence by recording a deed of trust in favor of a friend. This avoids the carrying costs of an actual bank loan. With this technique it is important to know the intelligence and the aggressiveness of the creditor. Some creditors may stop trying to collect when they realize that there is no equity in the residence. Others may dig deeper, and if the debtor cannot substantiate the transaction as an actual loan, the deed of trust will be set aside by a court as a sham.

In addition to stripping out the equity, it is also possible to protect the residence by transferring ownership but retaining control and beneficial enjoyment. This can be done in one of three ways.

An arm's-length cash sale is the best way to protect the residence (and the equity in the residence) because it is much easier to protect liquid assets (see discussion below) than real estate. While this technique affords the client the best possible protection, it is also the most radical and may result in additional income taxes. Thus, it is important to know the client's asset protection objectives and concerns and the extent the client is willing to go to protect his assets.

An alternative to an outright sale is the sale and leaseback of the residence to a friendly third-party on a deferred installment note. The debtor can make a credible argument that he does not own the residence without having to move out. This structure works only so long as the debtor can establish the legitimacy and the arm's-length nature of the sale. Practitioners should also consider the income tax consequences of the sale, and possible property tax consequences on the transfer of ownership.

The contribution of the residence to a limited liability company ("LLC") or a limited partnership may be another way to protect the personal residence. The protection afforded by LLCs and limited partnerships is derived from the concept of the charging order limitation, addressed in more detail below. While the charging order limitation is generally powerful, its usefulness may not extend to personal residences.

Certain state statutes require LLCs or limited partnerships to have a business purpose, and there is no business purpose in holding a personal residence in a legal entity. This may be remedied by forming the entities in states where there is no business purpose requirement. Other possible downsides include the loss of the Internal Revenue Code Section 121 gain exclusion on the sale of the residence, the loss of the homestead exemption, and the triggering of the due on sale clause in the mortgage.

The final available alternative to protect a personal residence is by contributing the residence to a qualified personal residence trust ("QPRT"). QPRTs are frequently used in estate planning and should be familiar to most estate planning attorneys. Because QPRTs are irrevocable trusts with spendthrift clauses the interest passing to the remainder beneficiaries is generally not subject to creditor claims (absent a fraudulent transfer challenge). The interest retained by the settlor is reachable by the settlors' creditors because that interest is self-settled. However, the interest retained by the settlor (the right to live in the residence, rent-free for a term of years) has little value to a creditor. It is difficult to imagine that a buyer at a foreclosure sale would want to purchase such an interest.

The QPRT is a great example of the practical efficacy of asset protection. While it does not afford the debtor a complete level of protection for the residence, it makes the residence sufficiently unattractive to a creditor so that in practice, creditors very rarely pursue residences in QPRTs

On the surface without investigating further, this seems to be an Asset Protection Strategy, not a Tax Reduction strategy.

Sandy

[jainen]

many important words

>>and only your primary residence<<

There are so many important words to highlight in your post, Sandy, but let's start with "only." The original post was about putting the home in WITH the rental properties. Besides the liability issue, the plan was to fraudulently deduct personal living expenses that were otherwise phased out.

A single-member LLC is a disregarded entity for tax purposes, so it shouldn't affect the interest deduction or Section 121 exclusion. Whether it will shield the home from creditors is a nice theory for lawyers to play with--your mileage may vary.

[Davc]

This sounds like a lawyers way to avoid an "Abusive Trust Scheme". I wonder how long it will take to show up on "The Dirty Dozen".

[OldJack]

All the entity scheming to protect the residence from liability? The odds of the liability make it more likely that "It Won't Happen". And it is much simpler to have insurance rather than pay all those outrageous attorney fees.

[JG EA]

Protecing your home

Did the clients ever hear of insurance?