Tax-Smart Option for Investing in Real Estate

Real estate can be an attractive long-term investment. But the legal entity you select to own property can have important tax implications. Here’s why single-member limited liability companies (SMLLCs) are generally a better alternative than corporations from a federal income tax perspective.

Tax Benefits for Disregarded SMLLCs

SMLLCs — that is, limited liability companies with only one owner (member) — are popular vehicles for business and investment activities. Why? These entities provide federal income tax advantages, while providing liability protections similar to those for corporations.

Specifically, under the “check-the-box” IRS regulations, you can generally ignore the existence of an SMLLC for federal tax purposes. Exceptions include:

• When you elect to treat an SMLLC as a corporation for federal income tax purposes (relatively unusual), and
• For purposes of federal employment taxes and certain excise taxes.

Disregarded SMLLCs Are Disregarded for Only Federal Income Tax Purposes

Disregarded single-member limited liability companies (SMLLCs) are ignored for federal income tax purposes. However, they’re treated as separate taxpayers for federal employment tax purposes and for certain federal excise tax purposes. Specifically, disregarded SMLLCs are treated as corporations for federal employment tax purposes.

Just like any other corporate employer, SMLLCs must:

• Withhold Social Security and Medicare taxes (FICA taxes) from employee paychecks,
• Withhold federal income taxes from employee paychecks,
• File federal payroll tax forms, such as W-2s and Forms 941.

Disregarded SMLLCs must also pay certain federal excise taxes and file Form 720, “Quarterly Federal Excise Tax Return.” There also may be additional state and local tax filing requirements for SMLLCs. Work with your tax advisor to make sure you’ve covered all the bases.

When you choose to not treat an SMLLC as a corporation for federal income tax purposes, the SMLLC has disregarded entity status under the tax rules. The treatment of a disregarded SMLLC is simple: The IRS considers the entity’s business or investment activities to be conducted directly by the SMLLC’s owner.

With a disregarded SMLLC, there’s no need to file a separate federal income tax return for the business or investment activities. Instead, the federal income tax results are reported on the owner’s return. For example, if the owner is an individual, the results for a rental property activity are reported on Schedule E of his or her federal income tax return. Likewise, when a corporation owns a disregarded SMLLC, it’s considered an unincorporated branch or division of the corporation, and the results are reported on the corporation’s federal income tax return. Similar treatment applies to SMLLCs that are owned by partnerships and multi-member LLCs that are treated as partnerships for federal income tax purposes.

Liability Protections

Although the existence of a disregarded SMLLC is ignored for federal income tax purposes, its existence isn’t ignored for general state-law purposes. Therefore, a disregarded SMLLC will provide its owner the liability protection benefits specified by the applicable state LLC statute. These liability protection benefits are usually similar to those offered by a corporation.

Investors may be particularly concerned about exposure to various liabilities related to owning real property, ranging from environmental issues to personal injury claims from tenants or visitors. Setting up one or several disregarded SMLLCs to own your real estate assets addresses the liability-exposure problem without adding tax complexity.

Additional Tax Advantages

For federal income tax purposes, the owner of a disregarded SMLLC is considered to directly own any real estate that’s held by that entity. So, when real property owned by the SMLLC is exchanged for other real property, it’s treated as an exchange by the SMLLC’s owner under the favorable Section 1031 (like-kind) exchange rules.

Several IRS private letter rulings have confirmed that Sec. 1031 exchange treatment is allowed for property swaps involving SMLLCs. So, if you currently directly own real property that will be relinquished in an upcoming Sec. 1031 exchange, consider setting up a disregarded SMLLC to receive the replacement property. The exchange will qualify for Sec. 1031 treatment, because both the relinquished and replacement properties are considered owned directly by you for federal income tax purposes. However, under applicable state law, the SMLLC offers protection from liabilities associated with the replacement property, because your name won’t appear in the chain of title for the replacement property.

Similarly, the IRS has issued a private ruling confirming that property owned by a disregarded SMLLC is treated as owned directly by the SMLLC’s owner for purposes of the favorable Sec. 1033 tax-deferred replacement rules. These rules apply to property that’s involuntarily converted due to condemnation or destruction.

Beware of State and Local Tax Issues

While a disregarded SMLLC can be an effective real estate ownership vehicle under the federal income tax rules, watch out for possible state and local tax implications. For example, Texas SMLLCs generally must pay the state’s corporate franchise tax, while individuals and partnerships are exempt from it.

Even if a disregarded SMLLC isn’t required to pay any entity-level state taxes, most states impose annual registration fees. Some states also may require the filing of separate state income tax returns for SMLLCs.

On the other hand, using a disregarded SMLLC can sometimes be beneficial under local tax rules. In one real-life case, the taxpayer acquired a disregarded SMLLC that owned the replacement property for a Sec. 1031 exchange. This indirect acquisition of the replacement property allowed the taxpayer to avoid local real estate transfer taxes that would have otherwise been due. Meanwhile, the transaction was treated as a direct acquisition of the replacement property under the Sec. 1031 exchange rules, because the SMLLC’s existence was disregarded.

Putting an SMLLC To Work for You

Disregarded SMLLCs aren’t just advantageous for individuals who invest in real estate. All types of investors — including corporations, partnerships and limited liability companies — can enjoy the tax and legal benefits associated with these entities. Contact your tax advisor to determine whether an SMLLC is right for your situation.

Copyright 2024

This article appeared in Walz Group’s August 26, 2024 issue of The Bottom Line e-newsletter, produced by TopLine Content Marketing. This content is for informational purposes only.