While real estate investors might own real estate directly as sole proprietors, rental property is typically held in a trust or limited liability company (LLC). Despite the fact that an LLC and a trust serve different functions, both types of entities can aid investors in safeguarding their assets and lowering potential risk.
This post will discuss the distinctions between an LLC and a trust as well as the benefits and drawbacks of holding rental property in an LLC as opposed to a real estate trust.
Key Considerations:
- Asset Protection: Irrevocable trusts offer limited asset protection, as they do not shield your personal assets from lawsuits or creditors.
- Tax Benefits: Irrevocable trusts can help reduce estate taxes and capital gains taxes, but they do not offer tax deductions for depreciation or other expenses.
- Control and Flexibility: Once you transfer your property to an irrevocable trust, you relinquish control over it, and the trustee manages it according to the trust’s terms.
- Cost and Complexity: Setting up and maintaining an irrevocable trust can be costly and complex, requiring legal and financial expertise.
Understanding Irrevocable Trusts:
An irrevocable trust is a legal arrangement where you, the grantor, transfer ownership of your rental property to a trustee. This trustee manages the property according to the terms outlined in the trust document, and you relinquish control over it. Irrevocable trusts are often used for estate planning purposes, as they can help reduce estate taxes and ensure that your property is distributed according to your wishes.
Benefits of Putting Your Rental Property in an Irrevocable Trust:
- Reduced Estate Taxes: By transferring your rental property to an irrevocable trust, you remove it from your taxable estate, potentially reducing your estate tax liability. This can be especially beneficial if you have a large estate or anticipate significant appreciation in the value of your rental property.
- Lower Capital Gains Taxes: When you sell a rental property held in an irrevocable trust, the trust pays the capital gains tax, not you. This can result in significant tax savings, especially if you are in a high tax bracket.
- Protection from Creditors: While irrevocable trusts do not offer complete asset protection, they can make it more difficult for creditors to seize your rental property. This is because the property is no longer legally owned by you, but rather by the trust.
- Privacy and Anonymity: Irrevocable trusts can provide a degree of privacy and anonymity, as the trustee’s name is typically the only one publicly associated with the property.
Drawbacks of Putting Your Rental Property in an Irrevocable Trust:
- Loss of Control: Once you transfer your rental property to an irrevocable trust, you relinquish control over it. The trustee manages the property according to the terms of the trust, and you cannot sell it or make major decisions without the trustee’s consent.
- Cost and Complexity: Setting up and maintaining an irrevocable trust can be costly and complex. You will need to work with an attorney to draft the trust document and may need to hire a professional trustee to manage the property.
- Limited Asset Protection: Irrevocable trusts do not offer complete asset protection. If you are sued personally, creditors may still be able to seize your assets, including the rental property held in the trust.
- No Tax Deductions: You cannot claim tax deductions for depreciation or other expenses related to the rental property once it is transferred to an irrevocable trust.
Making an Informed Decision:
Deciding whether to put your rental property in an irrevocable trust is a complex decision with significant financial and legal implications. Carefully consider the benefits and drawbacks outlined above and consult with a financial advisor and attorney to determine if an irrevocable trust is the right choice for your situation.
Additional Considerations:
- Type of Irrevocable Trust: There are different types of irrevocable trusts, each with its own advantages and disadvantages. Consider the specific goals you want to achieve with the trust when choosing the right type.
- Trustee Selection: Choosing a trustworthy and competent trustee is crucial for the success of your irrevocable trust. Consider the trustee’s experience, qualifications, and fees when making your decision.
- Tax Implications: Irrevocable trusts have complex tax implications. Consult with a tax advisor to understand how the trust will affect your tax liability.
Putting your rental property in an irrevocable trust can offer several benefits, including reduced estate taxes, lower capital gains taxes, and increased privacy. However, it is important to carefully consider the drawbacks, such as loss of control, cost, and limited asset protection. By weighing the pros and cons and consulting with financial and legal professionals, you can make an informed decision about whether an irrevocable trust is the right choice for your rental property.
LLC for rental property
According to the laws of the state where a rental property is located, an LLC is a distinct business entity.
The individual owners of an LLC are called “members,” and most states do not restrict the type of ownership or the number of members. As the Internal Revenue Service (IRS) explains, members of an LLC can be corporations, other LLCs, foreign entities, and individuals.
States typically permit “single-member” LLCs with just one owner. To hold investment property, a real estate investor might think about creating a single-member LLC rather than holding rental property as a sole proprietorship.
Pros
- Compared to corporations, LLCs can be simpler and less expensive to form and run because they are separate business entities from their members.
- Since an LLC can typically have an infinite number of members, group investing may find an LLC to be a viable option.
- Members of an LLC may contribute cash in the form of loans to the LLC, equity capital, or a combination of the two.
- When state laws permit, single-member LLCs can be created to hold rental property instead of owning it under a personal name or “doing business as” (DBA) name.
- In order to prevent the double taxation of corporate profits, income from rental properties held in LLCs is passed through to each member and reported on individual tax returns. Income taxes are then paid according to each member’s individual rate.
- In the case of a lawsuit or bankruptcy, each member’s other personal and business assets are typically shielded from creditors’ claims and legal liability.
- If an LLC’s operating agreement is followed, its members may also purchase and sell individual shares without having to sell the real rental property.
Cons
- Many states mandate that members hold annual meetings and impose an annual LLC renewal fee.
- Even though LLCs typically do not pay taxes, they are nevertheless required to file yearly tax returns and give each member a Schedule K-1 detailing their respective shares of income or losses, credits, and deductions.
- If it is determined that an LLC has committed an illegal act, its member liability protection may be restricted.
- Although individual LLC members might be able to sell their shares, some states mandate that in the event of a membership change, an LLC must be dissolved and a new LLC formed.
- In addition, an LLC structure may make it more difficult to raise additional capital than a corporation, such as a S corp, which may choose to sell additional stock shares rather than apply for a bank loan.
LLC vs. real estate trust
For asset protection, you can use both an LLC and a real estate trust. Although trusts and LLCs are established at the state level, their functions are somewhat different.
Like a S corporation, an LLC is a separate legal entity that is created to shield investors from possible legal liability and to keep other assets—such as personal and business assets—separate from those held by the LLC. However, when real estate is passed from one family member to another or from one generation to the next, a real estate trust is set up to prevent tax liability.
Before moving forward, bear in mind that you might want to consult a financial advisor or an attorney when choosing whether to hold rental property in an LLC or a trust.
Should I put my rental properties in a Trust?
FAQ
What assets should not be in an irrevocable trust?
Should I put my investments in a trust or LLC?
Can a trust depreciate rental property?
Should a rental property be put into an irrevocable trust?
The primary reasons to put a rental property into an irrevocable trust are to serve as a tool for inheritance and to restrict access to the assets by the beneficiaries. Because there is a trustee for the trust, beneficiaries must go through a trustee, presumably to regulate control of the disbursement of the assets.
Should you use an irrevocable trust to manage real estate?
Irrevocable trusts also add liability protection since you technically do not own the asset. Instead, it’s owned and operated by the trust, potentially deterring lawsuits and creditors. Using a trust to manage real estate also has some drawbacks, of course. These include:
Can a real estate trust be used for a rental property?
Real estate trusts also may be used by multiple owners of a rental property as a way to document ownership interests and relationships. Assets held in a trust are not treated as part of the grantor’s personal assets, which may help to lower an individual’s tax liability.
Should a rental property be in a revocable trust?
In general, with these benefits in mind, the more rental properties you own, the more sense it makes to have them in a revocable trust. An irrevocable trust is one where the grantor–let’s call her Mary Brown–turns over the control of the asset to a trust and no longer has any control.