Tax Issues to Consider When Owning Real Property in an LLC

SARASOTA, Fla. - June 15, 2013 - PRLog -- By Jo Ann Koontz, Esq., CPA

The Limited Liability Company (LLC) has become an increasingly popular vehicle for the foreigner buyer, or real estate investor seeking to establish a level of personal liability and asset protection, while minimizing their tax liability.

An LLC with foreign members has the flexibility to decide whether to be taxed as a partnership, C corporation or, in the case of a single-member LLC, it can elect to be disregarded as an entity for federal tax purposes. If an LLC chooses to be taxed as a partnership, or if a single-member LLC elects to be disregarded as an entity, the LLC's profits and losses are ultimately reported on the member's personal federal income tax return. If an LLC chooses to be taxed as a C corporation, the corporation reports the income earned and pays tax on it at the high corporate rate and the shareholder will also be taxed on any distributions received from that corporation. In order to avoid this double-taxation, most multi-member LLCs choose to be taxed as a partnership and most single-member LLCs elect to be disregarded as an entity for federal tax purposes.

A partnership does not pay tax, but it does compute income, deductions and credits on an annual basis. Information about the business is reported to the IRS on Form 1065 and to the individual partners on separate Schedule K-1. The partners report the partnership income on their own returns and pay any taxes due based on their own tax rates. A single-member LLC reports its income on Schedule C of their own returns filed with IRS and do not need to send another separate form.

There are no upper limits on the number of LLC members and no restrictions on the type of persons or entities that may be members. There are also no restrictions on ownership of subsidiary entities. LLCs are not restricted to a single class of stock, so LLC members have an ability to allocate gains, losses, deductions, and credits according to agreed-upon special allocations.

Losses from an LLC activity that is a passive activity of an LLC member are generally deferred until the member has passive income to offset the loss. These passive activity loss rules apply to most rental activities, except for some real estate rental activities in which a taxpayer "actively participates" and to trade or business activities in which the taxpayer does not "materially participate." Any losses that are not limited by the passive rules can be claimed to the extent of the member’s basis in the LLC. Basis is discussed below.

When an LLC distributes its property to a member or partner, there is generally no recognition of gain or loss until the member or partner disposes of the distributed property.

The rules governing transfers of interests in an LLC classified as a partnership for tax purposes indicate that gain or loss is generally recognized to the extent that the sales price exceeds, or is exceeded by, the selling member's basis in the interest sold. The gain or loss on the sale is treated as capital gain or loss.

This contradicts the common misconception that one can sell the company holding the real estate and avoid capital gain.

Sales of an LLC interest generally do not terminate the LLC for tax purposes. However, an LLC will terminate for tax purposes if there is a sale or exchange of 50 percent or more of the total interests in LLC capital and profits within a 12-month period. Generally, the LLC's operating agreement will determine what events will lead to dissolution.

As mentioned above, sale of an LLC interest is nontaxable to the extent of the member or partner's basis in the LLC. The basis of a member's interest is the initial capital contribution increased by the LLC's profits (or reduced by losses). In addition, a member of an LLC qualifying as a partnership can include his or her allocable share of the LLC's liabilities in the basis of his or her LLC interest. This basis increase gives the LLC member the ability to have a greater amount of money received on the sale of the interest distributed tax free and a greater amount of allowed losses to be claimed on member’s personal tax return.

For any investor considering a purchase of US real property, it is strongly recommended they consult with a US attorney or tax advisor experienced in this area of law to assist in structuring any transaction.

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Jo Ann Koontz is an attorney and CPA practicing in the areas of real estate, business law and taxation. She can be reached at (941) 225-2615 or joann@koontzassociates.com.