Transferring a rental property to an LLC isn’t as simple as signing a few documents. While it can help protect your personal assets, it’s a significant financial decision that requires careful planning and execution.

When you transfer your rental property to an LLC, you’re essentially changing the ownership structure of the asset. This seemingly simple action can sometimes set off a chain of tax-related events, from capital gains tax to property tax reassessments, with implications that can be far-reaching and complex.

Let’s examine some of the potential tax consequences you may face, including often-overlooked aspects such as transfer taxes, recording fees, and even the potential loss of stepped-up basis.

Tax consequences of transferring rental property to an LLC

Capital gains tax

Capital gains tax is a levy on the profit realized from the sale of a non-inventory asset. In investment real estate, it’s the tax you pay on the difference between the adjusted cost basis of a property and the net sale price

If you transfer a property to an LLC that you solely own and the LLC is treated as a disregarded entity for tax purposes, there may not be immediate capital gains tax implications.

But if the LLC has multiple members, the IRS could view the transfer as a sale, potentially triggering capital gains tax if the property has appreciated since its purchase.

Let’s say you purchased a rental property 10 years ago for $200,000. During your ownership, you:

• Made $30,000 in capital improvements (new roof and HVAC system)
• Claimed $50,000 in depreciation deductions over the years
• The property is now worth $400,000

If the IRS views your LLC transfer as a sale, here’s how your capital gains tax might be calculated:

• Current market value: $400,000
• Original purchase price: ($200,000)
• Plus capital improvements: +$30,000
• Less depreciation taken: ($50,000)
• Adjusted cost basis: $180,000

Taxable gain: $400,000 – $180,000 = $220,000

This $220,000 gain could be taxed in two ways:

1. The $50,000 in depreciation is “recaptured” and taxed at 25%
2. The remaining $170,000 is taxed at long-term capital gains rates (typically 15% or 20% depending on your income bracket)

This is why it’s crucial to structure your LLC carefully – the difference between a disregarded entity and a partnership could mean the difference between no immediate tax bill and owing significant capital gains tax.

Transfer taxes

Transfer taxes are fees imposed by state or local governments when real property changes ownership. These taxes are based on the property’s value or sale price and are typically due at the time of transfer.

You may be subject to transfer taxes, even if no money changes hands. However, it’s crucial to note that not all jurisdictions impose transfer taxes, and the rules can vary significantly from one location to another.

Recording fees

Recording fees are charges imposed by local government offices, typically the county recorder’s office, for officially documenting the transfer of real property ownership. These fees are separate from transfer taxes and are generally required regardless of whether transfer taxes apply in your jurisdiction.

When you transfer your rental property to an LLC, you’ll need to record this change of ownership with the appropriate local government office. This process involves filing a new deed that reflects the LLC as the property owner. The recording of this deed incurs a fee, which typically ranges from $50 to $150, depending on your location and the specifics of your document.

Property tax reassessment

Some jurisdictions may consider a transfer to be a change in ownership, potentially triggering a property tax reassessment. This is an important consideration because a reassessment could lead to higher property taxes if the property’s value has increased since the last assessment.

However, the rules regarding reassessment due to transfer to an LLC vary widely by location. Some jurisdictions have specific exemptions for certain types of transfers, including those to LLCs where the ownership remains essentially the same.

For example, California provides certain protections against reassessment when transferring property to a legal entity, as long as the proportional ownership remains the same.

Due-on-sale clause

Transferring your mortgaged rental property to an LLC effectively changes the ownership of the property. From the lender’s perspective, this could be seen as a sale or transfer, potentially activating the due-on-sale clause. If triggered, the lender could demand immediate repayment of the entire outstanding mortgage balance.

To avoid triggering this clause, it’s crucial to communicate with your lender early in the process. Many lenders are willing to work with property owners who want to transfer their property to an LLC, especially if the transfer is for asset protection purposes rather than a true sale.

However, even if the lender agrees to the transfer, they may require you to personally guarantee the loan. This means that despite the property being owned by the LLC, you would remain personally responsible for the mortgage. This requirement maintains the lender’s ability to pursue you personally in case of default, somewhat counteracting the liability protection offered by the LLC structure.

Loss of stepped-up basis

Stepped-up basis is a valuable tax provision that can significantly benefit heirs when they inherit property. It allows the cost basis of an inherited asset to be “stepped up” to its fair market value at the time of the previous owner’s death, potentially reducing future capital gains tax liability.

If you’re forming an LLC as a disregarded entity for tax purposes (typically a single-member LLC or one owned by a married couple in community property states), you’re likely to maintain the stepped-up basis benefit.

That’s because the LLC is treated as an extension of you for tax purposes. When you pass away, the assets held within the LLC will typically receive a step-up in basis, just as they would if you held them personally.

The situation becomes more complex if your LLC has multiple members or is taxed as a partnership. In these cases, the assets in the LLC don’t automatically receive a step-up in basis upon the death of an owner. However, it may be possible to achieve a step-up in basis through an election under Section 754 of the Internal Revenue Code.

Pass-through taxation

Unlike some other tax consequences we’ve discussed, pass-through taxation is generally a positive aspect of transferring your rental property to an LLC. This tax treatment is one of the primary reasons many landlords choose to form an LLC for their rental properties.

Pass-through taxation means that the LLC itself doesn’t pay taxes on its income. Instead, the profits and losses “pass through” the business to the individual owner(s). This is similar to how you would report rental income and expenses if you owned the property as an individual, avoiding the potential double taxation that can occur with C corporations.

Here are some key points about pass-through taxation for rental property LLCs:

• Tax treatment: The IRS typically treats a single-member LLC as a disregarded entity for tax purposes, meaning it’s taxed the same as a sole proprietorship.
• Reporting income: As the LLC owner, you’ll report your rental income and expenses on your personal tax return, typically using Schedule E of Form 1040.
• Tax rates: The rental income is taxed at your individual income tax rates, not at corporate tax rates.
• Deductions: You can still claim the same deductions for your rental property that you would as an individual owner, such as mortgage interest, property taxes, and depreciation.
• Self-employment tax: Rental income generally isn’t subject to self-employment tax, whether held personally or in an LLC (unless you’re considered a real estate professional by the IRS).

When it comes to tax filing, the process is relatively straightforward:

1. The LLC doesn’t file its own tax return (unless it’s a multi-member LLC electing to be taxed as a partnership).
2. You’ll receive all income and pay all expenses through the LLC.
3. At tax time, you’ll report all rental income and expenses on Schedule E of your personal Form 1040, just as you would if you owned the property personally.
4. You’ll need to keep detailed records of all income and expenses related to your rental property. This is where tools like Stessa can be invaluable, helping you track your finances and generate the reports you need for accurate tax filing.

How to form and transfer rental property to an LLC

Now that you understand the potential tax consequences, let’s walk through the process of forming an LLC and transferring your rental property into it.

Forming an LLC

Choose a name for your LLC:

Select a unique name that complies with your state’s LLC naming rules. Typically, it must include “LLC” or “Limited Liability Company” and not be already in use.

Appoint a registered agent:

Designate someone (often yourself or a company service) to receive legal papers on behalf of the LLC.

File Articles of Organization:

Submit this document to your state’s business filing office, usually the Secretary of State. It typically includes basic information about your LLC.

Create an Operating Agreement:

While not always legally required, this document outlines the LLC’s ownership and operating procedures. It’s crucial for clarifying roles and responsibilities, especially for multi-member LLCs.

Obtain an EIN:

Apply for an Employer Identification Number from the IRS. This is necessary for tax purposes, even if you don’t have employees.

Comply with other tax and regulatory requirements:

This may include obtaining business licenses or permits specific to your location and rental activities.

Transferring the rental property to the LLC

1. Prepare a deed:

Draft a new deed transferring the property from your name to the LLC. This is typically a quitclaim or warranty deed, depending on your state and preferences. You can also hire a lawyer familiar with real estate documents and the local recording process to handle this process.

2. Check for existing mortgages:

If the property has a mortgage, contact your lender to discuss the transfer and address any due-on-sale clause concerns.

3. Update the property insurance:

Inform your insurance company about the change in ownership and update the policy accordingly.

4. Record the deed:

File the new deed with your local county recorder’s office. This makes the transfer official and public.

5. Update leases:

Inform your tenants about the change and consider updating lease agreements to reflect the new ownership structure.

6. Transfer utilities and other accounts:

Change the name on utility accounts, property tax records, and any other relevant accounts to the LLC’s name.

7. Maintain proper documentation:

Keep detailed records of the transfer process, including all filed documents and correspondence with lenders, tenants, and government offices.

Remember, while these steps provide a general guide, the specific requirements can vary by state and individual circumstances. It’s often beneficial to consult with a real estate attorney or an LLC formation service to make sure you’re following all necessary steps and legal requirements in your jurisdiction.

Additionally, consider the timing of the transfer carefully. You may want to align it with the beginning of a tax year or after major property expenses to simplify accounting and tax reporting.

Simplify your LLC’s finances with Stessa

Once you’ve formed your LLC and transferred your rental property, it’s time to simplify your accounting and tax reporting. This is where Stessa comes in handy.

Stessa offers a comprehensive solution for rental property owners, including those operating through LLCs. With Stessa, you can:

• Automatically track income and expenses, categorizing them for easy tax reporting.
• Generate real-time financial reports, including those needed for Schedule E of your tax return.
• Manage multiple properties, streamlining your entire rental portfolio.
• Open a bank account for your LLC specifically designed for rental property businesses, making it easy to separate personal and business finances. You can even set up a separate bank account for each rental property, legal entity, or portfolio of assets.
• Access powerful tools for tracking income and expenses, calculating cash flow, and analyzing property performance.
• Manage a lot of the day-to-day tasks like collecting rent, screening tenants, advertising vacancies, and managing leases.

Sign up for Stessa today and experience the difference that smart, automated property management can make for your rental business.

The information contained in this article is provided for informational purposes only and should not be construed as legal, tax, or financial advice on any matter. Stessa is not liable for any actions taken or not taken based on the contents of this article and advises readers to seek professional legal, tax, or financial advice on which to base their decisions.